Why It's a Mistake to Pay For Your Car in Cash

Along with avoiding latte and smashed avocado, never borrow money to buy a car is the most common piece of money advice dished out in the media. It’s also wrong and could potentially cost you more than you think.

I’ve already smashed the fallacy behind coffee and avocado. Here I’m going to do the same to the idea that it’s smarter to pay cash for your car.  

The argument against paying cash for a car

The basis of the advice to never finance a car is that a car is a depreciating asset and you should never borrow to buy a depreciating asset.

1. The purchasing decision (should I buy a car? and should I buy this car at this price and 
2. The funding decision (should I pay cash? or should I take out a loan? and is this the right loan?)

Points to consider before buying a car

In my work as a money coach and advisor, I see a lot of people suffering from money stress and the most common causes of this are buying too much house and too much car relative to their income.

When it comes to buying a car, there are a few key rules to stick by:

Keep your car for as long as you can

The price you pay and how long you keep it matter much more than how you pay for it.

The rationale behind financing your car

This may sound odd, but it’s another one of those cases where psychology and behaviour trump maths when it comes to money.

Part of the confusion comes about because we have been led to think about a car as an asset. This leads us to treat it as a part of our wealth. 

In practice, it is better to think of it as an item of consumption – it wears out as we use it and at some point, becomes worthless. 

Think of the purchase price like prepaying your car rental for the period you’ll own it.

So, a loan is simply a mechanism to spread the cost over the period you will own it and avoid owning the bit of it you will never use (the period after you sell it).

Car ownership and depreciation

The biggest cost in owning most cars is the depreciation or gradual decline in value over time. The more expensive the car, the bigger the depreciation. 

The first year is the most expensive, although it is partially offset by lower maintenance costs. Newer cars also tend to be safer and more economical to run. The rate of depreciation then declines slowly until the value falls off a cliff after 10 years.

The pleasure of purchasing vs the pain of paying

Whenever we  buy something, we mentally weigh up the pleasure of purchasing against the pain of paying.

Whenever these two items are separated in time, we react differently.

This is why we spend more when we use credit cards and why a prepaid holiday feels better than when we pay as we play.

By paying cash for a car, the pain of paying occurs at the same time as we enjoy that new car feeling. But defers much of the true cost until the point at which we sell the car and realise how much it has depreciated.

The obvious costs of car ownership that you see in your daily budget (fuel, tyres, and servicing), account for only a quarter of the total cost.

You are borrowing the money anyway

If you are a homeowner with a mortgage or planning to be one, you have a choice of whether to use your savings to pay for a car or use them for your home loan. Instead of paying cash for your car, you could use your savings to increase the deposit on your home when you buy it or put it towards reducing your home loan balance if you already have a home loan.

Your choice here doesn’t affect the overall amount of debt you have.

But in practice, you will pay off a car loan over the period you own the car, not the 30 years of your home loan. This has a huge effect on the total interest you pay and potentially in the cost of lender’s mortgage insurance

Buying a car when you are already a homeowner

Here’s an example to help understand this better. Let’s say Sophie has a $500,000 home loan which she took out 2 years ago and now owes $486,757.  She has saved the purchase price of the 2023 Hyundai i30 Elite ($30,520).

She has a choice:

• She can pay the on-road cost to the dealer from her savings. Or 
• She can borrow the on-road cost of the car (using a typical 8.5% consumer car loan rate) and use her cash to reduce her home loan.

Either way, her total borrowings are the same.

The interest rate on a car loan is usually a little higher than home loan rates. In this case, the car loan rate of 8.5% compares to Sophie’s variable home loan rate of 5.5%.

If she pays cash for the car, she will pay a total of $ 132,639 in interest on her home loan over the five years and nothing for a car loan.

On the other hand, if she borrows for the car and uses her cash to pay down her home loan, she will pay $127,013 in interest on her home loan and a further $9,418 on the car loan for a total of $136,431 over the five years.

So, over the five years, she owns the car, she will pay roughly the same amount of interest either way.

But by choosing option 2 and paying $30,520 off her home loan, she will save $88,404 in home loan interest over the remaining 19-year life of her loan (and pay it off 3 years earlier).

Matching the loan period to the period of your ownership of the car means you pay for it over the period you use it, not over the 30 years of a home loan. The net effect is that you pay less interest overall. This result, although it might seem odd, is a consequence of Sophie spending the depreciation on something else rather than using it to repay debt. Most people do this because the depreciation doesn't show up in your day to day expenses - you see it only when you go to sell. A car loan forces you to focus on this cost each month. If instead, she made additional home loan payments equal to the depreciation while she owned the car, she would be in a better position.

Buying a car if you haven’t bought a home yet

For those considering buying a home in the future, using your savings to fund a larger deposit on your home instead of your car could also save you on lender’s mortgage insurance.

If Sophie was looking at buying her first home (for $600,000) and had saved $80,520 she could choose to either use $30,520 of this to pay cash for her car and so reduce her deposit available for her home purchase (to $50,000). 

Alternatively, she could take out a loan to buy the car and have a larger deposit for her home.

Either way, Sophie will need to pay the lender’s mortgage insurance on her home loan.

If she takes out the car loan and pays more towards her deposit, she will borrow a car loan of $30,520 and a home loan of $519,480 (a total of $550,000), and she will pay LMI of $8,150If on the other hand, she pays cash for the car, she will need a home loan of $550,000 and will be up for $19,703 in LMI. That’s $11,553 more – 38% of the price of the car!

Of course, everyone’s circumstances are different, so a good financial planner or broker will help you make the right decision.

Getting the right car loan matters

To make the most of your options, you still need to choose the right car loan. I’ve seen people pay interest rates as high as 30% or more on car loans. This is not good and should be avoided. But a small premium is OK.

Consult a good broker who will find the right loan for you. Do not let the car dealer talk you into a loan as these can often turn out to be very expensive.

If your credit is good and you are buying a new or near-new car from a licensed dealer, you can get rates only marginally above home loan rates.

This doesn’t work so well if you are buying a car privately or a car that will be seven or more years old when the loan period ends. Interest rates for car loans under these circumstances are usually higher.

Conclusion

Cash is not free and comes with consequences. When we spend it on one thing, it isn't available to spend on other things. This is a concept economists refer to as “Opportunity Cost” and is important when we seek to make decisions in isolation.In this case, the opportunity cost of the cash that we might have spent on the car was the value we could have generated by applying the cash.