There is a debate raging amongst consumers on the benefits of buying a car with cash versus paying for the car with a loan. It can be tough to decide with so many financial experts voicing their opinions. So, what is the right answer? How do you determine what the best option for you is?
The best way to determine which is right for you is to take stock of your financial assets and goals. If you have enough cash to pay for the car, accomplish your other monetary goals, and know the implications of using cash, this could be an excellent option for you.
The key to figuring out which is better for you is to understand how a car loan, interest, and the future value of money can affect your future worth.
Car Loan vs. Cash
Many people know the basics of a car loan. After you receive approval for a car loan, the bank will lend you money that you need to pay back with a specific interest percentage. You’ll need to make monthly payments to pay the loan down over time. The most common loan terms for auto loans are 36, 48, and 60 months. You might be able to get a 24, 72, or 84-month loan, but these come with much higher monthly repayments or interest.
Why Some Debt is Good?
Debt is a concept that is thousands of years old. People have been paying interest since before Roman times. It’s been used to forward the agendas of countries and individuals alike. When used correctly, debt not only increases the lender’s worth but can also be a powerful strategy for furthering the debtor’s interests.
People borrow money to finance items or services they cannot afford upfront. Everyday consumer use of credit cards, such as purchasing clothes, products, and services on a credit card, gives you belongings, but it doesn’t help you earn money.
Debt is a useful financial tool. You can use it to purchase something that will increase in worth greater than the amount you spent. It can also act as a tool to keep you from using cash and, instead, place it in accounts that will grow in value.
Lost Opportunity Cost of Cash
Opportunity cost is a concept based on the value of a dollar today being different from the value of a dollar tomorrow because of how you could use that dollar and inflation. You can use money in the bank to make more money. If you have money sitting idle in an account, you are losing the opportunity to make more. This is the lost opportunity cost of cash.
Many of us are taught by our parents to earn money and place it in a savings account for safe-keeping. Beyond that, most of us don’t know what else to do with our money, meaning we lose the opportunity to have our money help us make more.
Car Loans as an Alternative
When you take out a car loan, you plan to pay a certain amount per month for that car. Hopefully, you accounted for the amount you can reasonably afford, allowing for saving and expenses. The money you don’t spend on the car payment or living expenses probably goes into your bank account.
From there, you can save enough for emergencies and some fun. The money you have leftover can be put to use. For example, if you have $100 left over after accounting for all of your immediate and medium-range financial goals, you can place that money in a retirement account or some other form of lower-risk investment.
Every time you have some extra money, you can place it in one of these accounts. Over time, the account will grow from your contributions and the compounding interest. In this manner, your money is earning for you. Using this example as a frame of reference, here is a car-loan scenario.
If the price of a car were $10,000 and you financed the car using a 60-month term loan at 2.59% interest, your monthly payments would be close to $178 per month. If you had the $10,000 saved up for a car purchase and used the loan instead, you have $9,822 sitting idle in an account after the first month. After the second, you have $9644 — and so on.
What To Do Instead
Instead, if you were to use your monthly income to make loan payments, you could use the $10,000 to make money for you. Assuming you have an emergency fund and living expenses accounted for, you could open an Individual Retirement Account (IRA) and place $6,000 in it, which is the annual contribution limit. You can then keep the rest for a rainy day or invest in mutual funds with the appropriate amount of growth and risk for your age and income.
In this manner, you have taken advantage of the opportunity cost of money by allowing your money to grow. Without further contributions, your $6,500 would grow to approximately $28,000 in 20 years. Continuous annual deposits of $6,000 per year into the IRA for 20 years would net you close to $200,000 in your IRA (at a 5% rate of return).
If you were to use the $10,000 on the car, you would lose the opportunity to invest it for your future.
Putting it Together
Cash is a viable option when purchasing a vehicle if you want to reduce the present cost of buying a car. However, if you have a good credit score and can afford a monthly payment in addition to having an emergency fund, it might be more beneficial to use a car loan to purchase a vehicle.
The money you can make using a car loan debt to your advantage far outweighs the car loan’s total cost. A car loan lets you make the most of your money by using funds that you might otherwise have sitting around to help you make your future more secure.
Contact T&I Credit Union
At T&I Credit Union, our financial experts can guide you on how to invest your money and manage your auto loan. Contact us today at (800) 338-3908 to find out more about our free membership, car financing options, and investment accounts.