Recently, I’ve had discussions with several readers about the concept of paying cash versus taking out a loan for medium-sized purchases, such as an automobile. In order to demonstrate how cost-effective it truly is to buying a car with cash rather than taking out a loan, here’s a clear example that you can calculate at home.
Let’s say you just bought your first automobile with a loan. It’s a cheap one with only a small monthly payment, and your plan is to drive it for four years, then replace it with a car that costs $11,000. After the trade in, you’re planning to spend $10,000 on a car in four years.
You have two options here. First, you can just wait until then and buy the car with a 48 month loan. If you get this loan at 8%, the payments will be about $244.13 per month for 48 months. You can run the numbers yourself using the .
On the other hand, you can start paying for the car now by putting money into a savings account. If you put $188.90 each month into a savings account (which earns a 5.05% APY), you’ll have almost exactly $10,000 (actually, just a few cents over) after 48 months, with which you can buy the car by writing a check instead of taking out the loan.
With the second plan, you literally pay $55.23 less per month by saving up the money and then buying than buying and then paying off the loan.
What if you made a full equivalent payment into the savings account all 48 months? Instead of putting in just $188.90, you put in the $244.13 you’d have to pay for the loan. After 48 months, the account balance would be $12,924.27. You would have an extra $2,924.27! This could either mean a nicer car or a start on the car you would purchase after that.
Simply put, there is no better way to buy a car than to make the payments to yourself first, then write the check to buy the car. It doesn’t matter how good of a negotiator you are or how good of a rate you get, you can’t top a payment that’s 20% less.
Some people will argue that you have to get a car loan or else you’ll never get a car. This is arguably true for the first automobile that you own, but your first automobile should be just good enough to get you back and forth to work for a few years until you can afford to write a check for your next car.