Purchasing a vehicle can be a big decision and involves a lot of money. There’s a lot of questions like whether to go used or new, buy or lease, finance through the dealership or the bank or to even pay cash and avoid payments. On the matter of automobile loans it seems like they’ve really become a part of everyday life; it would almost seem strange not to have a monthly payment. We’ve become use to the idea of a loan that allows us to enjoy a car sooner than we might have been able to. But how much do we pay for that convenience?
My Tacoma was my first new car and I did a ton of research and haggled with dealers to get under sticker as much as possible. I was still in school and had saved up a little money and my parents offered to match whatever I put down. With my dad co-signing I got a 5%, 60-month loan through the credit union. So what is that loan actually costing me over 5 years:
- With $5,000 down payment and starting loan balance of about $15,000 = $2,025 in interest
- Without the down payment and a starting balance of $20,000 = $2,685 in interest
Not a huge difference, but the down payment dropped my monthly payment by $100. In both situations, the cost of the loan would run about 13.5% of the loan value. You can think of that 13.5% as a hidden tax on the car, which is more than the sales tax and other fees that get tacked on. Over a lifetime those interest payments can really add up. Aside from leasing (which I won’t even touch here), buying a car outright is our only other option. So why don’t we buy new cars with cash more often?
I think the biggest impediment is our need for instant gratification. I could have “paid” $330 dollars each month into a high-yield savings account for 5 years and bought my truck without getting a loan and saving myself over $2000 dollars and earning interest on my deposit in the process. So why didn’t I? Mostly because I wanted my new car sooner than later. I could have replaced my 1988 Ranger with a newer used car and looking back I probably should have explored that avenue more. Nevertheless I ended up with a new car. Instant gratification isn’t anything new in our culture, but we should be aware of the ultimate cost.
Looking into the future, we’re going to have to make some assumptions. Let’s assume a loan length of 60 months and everytime we’re done paying off the loan we trade the car in for 40% of the original value (depreciation is a you know what) and buy a new one that cost 10% more than the previous one. The first purchase has no down payment or trade in involved. Let’s say we start young and do our car buying cycle for 50 years. We’d end up with numbers like this:
| Car Loan # | Car Cost | Trade in Value | Loan Balance | Cost of Loan |
| 1 | 20000.00 | 20000.00 | 2700.00 | |
| 2 | 21000.00 | 8400.00 | 12600.00 | 1701.00 |
| 3 | 22050.00 | 8820.00 | 13230.00 | 1786.05 |
| 4 | 23152.50 | 9261.00 | 13891.50 | 1875.35 |
| 5 | 24310.13 | 9724.05 | 14586.08 | 1969.12 |
| 6 | 25525.63 | 10210.25 | 15315.38 | 2067.58 |
| 7 | 26801.91 | 10720.77 | 16081.15 | 2170.95 |
| 8 | 28142.01 | 11256.80 | 16885.21 | 2279.50 |
| 9 | 29549.11 | 11819.64 | 17729.47 | 2393.48 |
| 10 | 31026.56 | 12410.63 | 18615.94 | 2513.15 |
| Totals | $158,934.71 | $21,456.19 |
The trade-in acting as a down payment is what keeps this from being outrageous, actually these numbers don’t seem too bad. $21,500 in interest payments over a lifetime isn’t too big of a deal. Now let’s look at buying all of our cars outright. To accomplish the task of providing our own financing we have to delay our gratification and save. For the 5 years prior to a car purchase, we deposit the total cost / 60 into a high yield savings account every month, about $333 for a $20,000 car. The interest earned on the savings earmarked for a new car can be transfered to other investments for additional growth after the purchase. So by delaying the first car purchase and continuing that discipline we’ve saved $21,500 in interest payments, or have we?
What would happen if we took every dollar we would be giving to a bank in interest and invested it in a Roth IRA (all contributions and earnings can be pulled out tax-free during retirement). $21,500 over 50 years is $430 a year, $36 a month. That’s money we’d normally be giving away so why not invest it instead. Let’s say our IRA starts with a $0 balance, grows at 8% and we don’t worry about inflation yet.
Amount invested = $21,500
Simple earnings = $43,860
Compund earnings = $201,099
Total account value after 50 years = $266,459
Say wha?! That’s the power of compounding rearing its beautiful head. This is a mostly hypothetical situation, but the outcome and general idea are pretty clear. By delaying a car purchase and avoiding interest payments we are presented with the opportunity for incredible growth over the long term. Even without investing the difference you can save a good chunk of change. My scenario doesn’t take into consideration a longer period between purchases or the possibility of buying used cars, both of which would allow more income to be directed towards investments.
I’m not saying this is the absolute best way to purchase cars, but the hidden costs of automobile loans aren’t apparent until you crunch some numbers. I know some of you paid cash for your cars or even have the gall to drive cars not manufactured after the year 2000, but I hope this is enlightening for everyone. I plan on putting this into practice for our next car purchase.
I guess I don’t need very complicated math when it comes to car buying. At 5% interest rates, I have to be earning the same or more to make taking a loan a better deal. I can get guaranteed 5% with a CD, but it’s a wash.
I think the best car advice is to buy something you can afford, and drive it for a long time. :)
Yeah grandpa always said cash is king, he rarely used credit cards and always got the deals he wanted…
Borrowing money sucks and it’s a necessity for many, but you have to expect the lenders are making money on their investment, otherwise why would they lend money in the first place.
Sure you get a better deal when you walk in with cash to buy a car, in fact many dealerships don’t like you when you do that because they can’t make money off of selling you a high interest / low payment loan.
It’s an interesting word problem though I doubt many people will be patient enough to wait 50 years to buy a car!
I was curious, what specifically do you plan on putting into practice when you purchase your next car?
For me the most effective tool (as a non all cash buyer) has been taking in a simple financial calculator when negotiating the final price.
So when they bring back the *magic* number from the *magic* financier’s pit… and you ask what the interest rate is and when of course they “don’t know” you can easily input the known variables and solve for the missing variable and present them with the crazy interest rate they’re trying to charge.
I had a lot of fun buying my Silverado and loads more (but drove Lori nuts) during the purchase of my Sierra.
Also I was curious about the Roth IRA you mentioned, did it include any risk and where are you getting an 8% return?
Driving a car for a long time is the best thing you can do. Buying it used and driving it for a long time is even better. $0 monthly payments is even better then paying monthly payments to yourself.
Angelo maybe I wasn’t clear, here’s the quick version of the plan:
Save up enough cash to buy a car, might take 5 years or however quick you want to get to your target, that’s up to you.
Once you have enough go buy your car and immediately start the saving process over again. So all you have to wait for is that initial period where you save for the first purchase. Now you’ll just be making monthly payments to your savings account rather than a bank.
So you have hard savings from not paying interest and the potential for a lot of growth in the long term on the extra money available to invest.
8% is actually a historical average used for most retirement planning with inflation taken into consideration. Some use 10.7-12% as an average of return on the S&P 500, so 8% might be considered conservative by some.
Andrew wasn’t saying wait 50 years to buy a car, he was evaluating 10 car purchases over the course of 50 years.
Before you post something negative, at least read the darn thing.
Nate, I did read it which is why I asked the question I did. I wasn’t trying to be negative.
I had a legitimate question because he stated he’d plan on putting this into practice for his next car purchase… I wanted to know *what* was going to be put into practice.
His answer brings out further clarity to the original post, for me.
But I realize this post was more so to demonstrate the knowledge / benefits of personal investments and how future value is worth more due to compounding interest.
You said:
“It’s an interesting word problem though I doubt many people will be patient enough to wait 50 years to buy a car!”
That’s not a question, so I guess it’s just a comprehension problem.
Nate,
You’re right, that’s both not a question and I did say it. But I do think the line below that statement was a question:
“I was curious, what specifically do you plan on putting into practice when you purchase your next car?”
Which Andrew answered well and even provided an example. It really did help to bring clarity to his post.
Andrew, thanks for answering my question.
Also, I guess I should be sorry for being negative (really?) and for my “comprehension problem”
So here’s another question. Nate, why are you so angry with me asking for further clarification?
I’m not angry, just think about how your responses might come across to the people reading them. Same goes for any conversation in life. In a separate conversation you asked me what hospital we’re delivering at, and then proceeded to tell me how crappy it was. Thanks, but no thanks. You’re entitled to your opinion, but that doesn’t mean you always need to give it.
No big deal.
Sorry for this Andrew,
Well now I see what you snapped because I really wasn’t trying to be mean posting here. I was failing to see a practical / real-life use for all the number crunching and I had an honest question… to which Andrew gave a great example to further explain his post.
Nathan, I know you enjoy arguments and I’ve seen you be mean and freely express your opinion in comments on other blogs, so I guess your opinion and right to have fun are more acceptable than mine.
I’ll admit there are times where I will post a silly comment knowing it will provoke an equally silly argument (like the funny cat pictures post on here, that was a fun one!)
I don’t see what the big deal is, it’s a blog!
I’ll make sure before I post a comment or opinion I double check and re-think it I guess I broke some blog etiquette?
I’m glad to know what the real cause was now. I’ll consider this done and thank Andrew again for posting the original post and apologize for mucking up his comments.
I call a truce.
I almost forgot, the hospital thing…
I wasn’t intending to question your judgment or insult you, but I’m sure I did.
The truth is I have SERIOUS issues with that hospital due to my grandmother’s untimely death after arriving there for care of a broken leg…
Yes, I’m very upset with that place and I know that I just automatically bash it every chance I get.
I don’t remember specifically what I said but I’m it wasn’t the proper time to mention it. For this I am sorry and I truly do wish you well and look forward to seeing your baby on the outside!
You know, my parents tried to pay cash for their car. The dealership wouldn’t let them. They had to deal with managers, i.e. non retards.
I have a question that goes a little deeper than you did here.
I’m trying to weigh the difference between buying a car outright and getting a loan for a couple of thousand dollars that I can pay off relatively quickly.
The reason for the loan is to get a good credit record added to my credit report and so that I won’t be looked at as a first time buyer if I ever want to get a loan for something in the future.
Do you know how to value that additional credit rating and status versus the cost of the interest for the loan?
Hi John,
If you’re starting out like I was then a car loan really isn’t a huge deal. Making the monthly payments should have a positive impact on your credit history. It also depends on your situation, if you can buy the car outright how much does that leave in savings? It might be better to get the loan and keep that money tucked away just in case (preferably in a 3-4% savings account).
My post was trying to get at the problem of instant gratification and what it could potentially cost over a lifetime. You sound like you’ve got a pretty good handle on things so I would say go ahead and get the loan, the cost will be pretty low. If you were looking at a $30k loan then that’d be a whole other story.
ALL I wanted to know if I can pay cash for auto and trade in my clunker
and get the 4500 and other factory rebates? I know they don’t like you very
much because they don’t make money on high intrest loans. I like to deal in black & white no hidden cost. I’m lucky enought to plunk cash money down
for an new car. I’m no fool so they the dealers best not try hidden cost
on me.I don’t see how you can go wrong with cash and factory rebates a
person could save himself or herself a nice chunk of change and no coupon
book. All I see is taxes and insurance and a lot of money to be saved why not and don’t give me your little nerd ball excuses why I shouldn’t, all Iv’e been getting is negative feed back. Will someone give me an straight answer with out the mumbo jumbo thanks bet you cant Jim
Jim,
If you can qualify for the Clunker program and still get the price on the car you want then why should it matter what other people think about paying cash for a car? As far the dealership goes, don’t tell them you’re going to pay cash until you have your price agreed upon. Many dealers will give you quotes over the phone and will try to beat competitor quotes. If a dealer won’t do that, move on, they don’t deserve your business. If you walk in with your quote and they try to play games, say thank you and walk out.
Dealerships might be playing games with their pricing because of the Clunker program. The government giving away free money will artificially increase prices and you might end up paying closer to MSRP. I haven’t really been looking at prices, but if you can get a car close to Invoice and qualify for Clunkers, then that sounds like a good deal to me.
We paid off my wife’s car back in December and I’m paying off my loan early. It doesn’t make since to put money in savings (1.5%) when my loan is at 5%. Once both of our cars are paid off, some of that extra money will go to savings to pay cash or get close to paying cash for our next car.
Also, the value of the Clunkers $4,500 is reduced by your old cars potential resale value. If you can sell your old car to a private party for $3,000, then you’re only realizing $1,500 in savings. If your old car is worth more than $4,500 then you are actually losing money trading it in under Clunkers.