Financing a Car Can Be Better Than Paying Cash

Opportunity cost is an economic term and is defined as the potential reward that you give up when you choose one option over another. For example, say that you have $100 to spend on new clothes. If you decide to spend that $100 on a few pairs of pants, you give up the opportunity to spend the $100 on different articles of clothing such as shirts.

Opportunity cost is a key principle to understand when you are making a financial decision. If you have limited resources, there is always going to be an opportunity cost when you spend those resources. When you spend dollars in one area, you give up the opportunity to use those dollars in another area.

This economic idea can help you decide when to pay cash for a car, and when to finance it. Some individuals will advise that you should only pay cash for a car and not risk borrowing money. However, opportunity cost can reveal that paying cash for a car is not always your best bet.

If financing a car will cost more than what your cash could earn, it makes sense to pay cash for a car. What does this mean exactly? Say that you have saved up $20,000 worth of cash. You currently have this cash sitting in a high yield savings account that earns a 5% APY.

You are in the market for a new car and are trying to decide whether to buy that car with the cash you have saved or finance the car. For this reason, you shop around for financing to see what rate you could get. After doing this, the best rate you are able to find for yourself is 7%.

In this scenario, it makes more sense to buy your new car in cash. Your cash currently earns 5%, but it would cost you 7% to finance the car. It does not make sense to get financing that is going to cost you more than what your cash currently earns.

When you buy the car in cash, you save yourself the extra interest that you would have paid if you were to have financed the car. There is a hidden opportunity cost in making this decision that you need to be aware of, but we will evaluate that later on.

If financing a car costs less than what your cash can earn, it makes sense to finance the purchase of a car. Let's use the same initial assumption in the scenario above. You have saved up $20,000 of cash in a high yield savings account that earns a 5% APY.

You are once again trying to figure out if it is better to use the cash you have saved up to buy a car or finance it. You go out and shop around for the best auto loans. After doing this, you are able to secure financing at a 2.5% interest rate.

Since you are able to finance the car at a cheaper rate than what your cash earns, it makes more sense to finance the purchase of the car. You do not want your cash to stop earning 5% if you can borrow the money at a cheaper rate.

This does not mean that you go out and get a $1,000 per month car payment. You still need to be aware of your budget and get a reasonable car loan that will not derail your finances. The point of this example is to demonstrate the principle of opportunity cost.

If you were to pay cash in this scenario, your opportunity cost would be the interest that your cash could have earned if you were to finance the car. Let's explain this further. Assume that you are going to finance the purchase of a $20,000 car at a 2.5% interest rate over 5 years. Assume that all fees and taxes are included in the price of $20,000.

To keep things simple, we are going to assume that you did not put any money down. Over the course of the loan you will pay $2,645 in interest. However, it is important to remember that you have $20,000 sitting in a high yield savings account that earns a 5% APY.

Assuming that you did not put any more money in this account, the balance at the end of 5 years would now be $25,667. Your cash earned $5,667 over the course of 5 years. This is $3,022 more than the interest that you would pay out from financing the car.

If you were to have paid cash for the car in this scenario, your opportunity cost would be $3,022. In other words, you would have lost $3,022. This may seem like a trivial amount, but when you factor in opportunity cost to every financial decision that you make in life, these small amounts can add up to a lot more money in your pocket.

Paying cash for a car is straightforward. You simply write a check to buy the car. It makes sense to do this when financing a car would cost more than what your cash could earn. We mentioned before that there is a hidden opportunity cost to buying a car in cash. Let's look at what that means.

Again, you have $20,000 saved in a high yield savings account that earns 5% APY. Financing the car would cost you 7%, so it makes sense to buy the car in cash. Doing this saves you the additional interest you would have to pay by financing the car.

However, when you pay cash for the car, you lose out on the opportunity for your cash to earn 5% from your high yield savings account. Although you do not have a car payment, you need to act like you have a car payment and repay yourself the interest that you lost out on.

Assume that you would have financed the car for 5 years. If you did not pay cash for your car, your cash balance at the end of 5 years would be worth $25,667. When you pay cash for the car, you lose out on the opportunity to have this balance at the end of 5 years.

For this reason, you need to act like you have a car payment at 5% to repay yourself the interest you lost out on. Every month for five years, you are going to save $427. When you do this, you repay yourself the interest that your cash could have earned when you paid cash for the car.

When you finance a car, you need to consider several items. First, how much are you going to put down on the car? Secondly, how long are you going to finance the car for? Thirdly, how much car can you afford?
When you do a Google search for the ideal down payment on a car, you will typically get an answer of 20%.

So, if you bought a $20,000 car, you would put down $4,000. This advice is not unreasonable. It will give you equity in the car and reduce the monthly payment. However, is this the best thing to do? Remember, every financial decision has an opportunity cost.

When you put this $4,000 into the car in the form of a down payment, you lose out on the opportunity to use those dollars elsewhere. If we continue with the assumption that you were holding your cash in a high yield savings account that was earning 5% APY we can quantify this opportunity cost.

If you were to leave this $4,000 in your high yield savings account, it would earn $1,133 over the course of 5 years. By putting 20% down on your car when you finance it, you will automatically lose $1,133 over the course of 5 years.

For this reason, you should put as little down as possible when you buy a car if your cash can earn more than what it costs to finance the car. There are a couple of arguments against this. First, your monthly payment will be higher when you don't put anything down.

If you cannot afford the monthly payment of a car when you put nothing down, you are buying too much car. Second, when you don't put anything down you may be upside down. This is when you owe more on the car than what it is worth.

If you find yourself in a precarious financial situation, you may have to sell the car and you would owe the difference. However, since you financed the car and left your cash in a high yield savings account, you would have money available to cover yourself if this happened.

Your second consideration when you finance a car is how long you should finance it for. Under the opportunity cost framework, you should finance a car as long as you can. Sounds counterintuitive to the typical advice online, but hear us out.

If your cash will continue to grow at a higher rate than what it costs to finance the car, you want to continually have your cash grow. The reality is that every purchase you make is financed. It is either financed by yourself or by someone else like a bank.

If it will cost you less to have someone else finance a large purchase like a car, you do not want to wipe out your cash that is earning you more money. Keep in mind that you have to be careful when you do this. If you finance a car that is 15 years old, you have to look at the lifespan left on the car.

You might be able to get another 5 years out of the car, so you would finance it for 5 years. However, if a car is brand new, you can finance it for longer so you can do other things with your cash, such as invest it or keep it in a high yield savings account.

Finally, you need to think through how much car you can afford. Lots of financial experts will recommend not spending more than a certain percentage of your income on a car. You might hear things like, never spend more than 25% of your gross income on cars and their expenses.

This is not an unreasonable starting place. However, let's take a step back and look at your entire financial picture. A good financial plan will have two things. First, it will have safety nets in place to keep you from going backwards financially.

This can include having robust insurance, such as car, home/renters, or life insurance, and a well funded emergency fund. Second, it will have a way for you to build wealth for your future. An example would be investing in stock investment funds through a Roth IRA.  

The money that you have left over in the middle is what you can spend on your other expenses and lifestyle. For example, say that you have an after tax income of $5,000 per month. You put $500 towards your safety net and $1,000 towards your future.

This leaves you with $3,500 to spend on your other expenses and lifestyle per month. When you budget out your expenses, you can get a better idea of how much car you could afford. After doing this, you might find out that you have $500 per month that you could put towards a car and its related expenses.

Keep in mind that the more of the money that you allocate towards a car, the less you have to use for other things. You might be an individual who values taking a yearly vacation. As opposed to spending $500 per month on a car, you might only spend $250 per month on a car and save the remaining $250 for a year to go on vacation.

When you look at your entire financial picture, you evaluate what is truly important to you. If you don't have enough money to create a safety net, put towards your future, and spend on a lifestyle that you enjoy, you are likely buying more car than you can afford.

Many individuals that believe the best financial decision is to not borrow money will often advocate for this by using emotions. They argue that having monthly payments will cause unnecessary amounts of stress and that it is always best to pay for a car in cash.

For some individuals this is true. The reality is that large car payments can crush you financially if you are not smart when you borrow money. If you truly believe that paying cash for a car is always best, there is nothing wrong with doing so.

However, as emphasized thus far, it is vital to understand opportunity cost. When you pay cash for a car, you lose out on the opportunity to use that money elsewhere. Over time, this can cost you thousands of dollars if your cash can earn more than what it costs to finance a car.

Transportation is a necessity. Up until this point, we have looked at examples that had an underlying assumption - you had cash saved up that you could use for a car. However, this is not a reality for everyone. If financing a car is your only option, there are a few things to think through.

Even though you do not have cash for a car, you can use the same framework of opportunity cost to figure out how to effectively manage a car loan. For example, say that you go out and shop for financing. The best rate you are able to find for yourself is 7%.

If you were to have any cash available, you would keep it in a high yield savings account that earns a 5% APY. Since financing the car is more expensive than what your potential cash could earn, it would make sense to pay off the loan as fast as possible.

Say that the car you bought cost you $15,000 and you were able to pay it off early in 4 years. You have now solved your transportation problem. However, there is an opportunity cost in this equation. When you financed the car, you lost out on the opportunity to take the money that went into your car and put it into a high yield savings account.

Once the car is paid off, you want to act like you still have a car payment and repay yourself the money that you lost out on as you were paying off the car loan over the course of 4 years. Every single month for the next 4 years after your car loan is paid off, you will save $381 to repay yourself the interest you lost out on.

On the flipside, say that you were able to obtain financing at a 2.5% interest rate. Assume that a high yield savings account that earned 5% was still available. Instead of paying off the car as fast as possible, you could pay it off over a longer period of time.

By doing this, you could take any extra money you had by financing the car over a longer period of time and put it into a high yield savings account earning 5%. Since your cash can earn more than it costs to finance the car, it does not make sense to pay off the loan as fast as possible.

When financing is your only option, you can still use an opportunity cost framework to manage the loan. Keep in mind that when financing is our only option, you should focus on buying a reliable car that will get you from point A to point B.

Since you do not have any cash to protect yourself from a precarious financial situation, it is not the time to go out and buy your dream sports car when your only option is to finance it. In other words, you are not in the position to take on that much risk when financing a car is your only option.

The bottom line is that understanding opportunity cost can help you determine whether it makes sense to pay cash for a car or finance it. If financing a car will cost more than what your cash could earn, it makes sense to pay cash for a car.

When you pay cash for a car, you need to repay yourself the money and interest that your dollars could have earned. If financing a car costs less than what your cash can earn, it makes sense to finance a car. When you finance a car, you put down as little as possible so that cash can keep growing.

For some individuals, having a car payment will put too much emotional strain on them. However, paying cash for a car is not always your best bet, and in some circumstances it may be your only option. If financing a car is your only option, you can still use an opportunity cost framework to manage that loan.