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 dealt with the coffee (and smashed avocado) argument HERE but in this article I’m going to do the same for car loans.
Why this advice is so common
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.
But this conflates two issues which results in muddled thinking:
- The purchasing decision (should I buy a car? and should I buy this car at this price and
- The funding decision (should I pay cash? or should I take out a loan? and is this the right loan?)
What you should do instead
If you are buying a new (or near new) car and have any other debt (or are likely to during the period you will own the car), don’t pay cash. But make sure you get the right car loan at the right price.
Why it matters
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:
If you drive less than 5,000 kilometres a year, live in an urban area, and don’t use it to commute, you are likely to be better off using a share car service like GoGet.
If you are going to buy a car, buy as cheap a car as your ego can afford – and never pay more than 3 months’ salary (gross income before taxes) for your daily drive.
Keep your car for as long as you can.
But if you are going to buy a new (or near new) car, you are likely to be better off taking out a car loan than paying cash. But make sure you get the right car loan at the right price.
The price you pay and how long you keep it matter much more than how you pay for it.
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).
It’s the depreciation
The biggest cost in owning most cars is the depreciation (decline in value), and 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.
According to the RACV, depreciation accounts for almost 40% of the cost of owning a basic car (such as a Hyundai i30) for 5 years from new.
Interest accounts for only 12% even if you borrow the total purchase price.
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 costs that you see in your daily budget (fuel, tyres, and servicing), account for only a quarter of the total costs of car ownership.
This leads us to overvalue the benefit we get from the purchase and under estimate the cost and this leads us to spend more than we otherwise would on a car.
By using a loan on the other hand, the depreciation shows up in our loan repayment and is experienced as we drive the car. The monthly loan payment includes interest on the money outstanding, of course, but the bulk of the payment represents repayment of principal which is closely related to the decline in value of the car.
This can be matched even more closely by choosing a “balloon” (or lump sum) payment at the end of the loan equal to the expected trade in value.
For example, a 5-year 40% balloon would mean that only 60% of the initial loan is repaid over the 5-year term, with the balance to be repaid by sale of the car.
You are borrowing the money anyway
If you are a homeowner with a mortgage, (or planning to be), you have a choice as to whether you use your savings to pay for the car, or apply it to your home loan. You could instead, increase the deposit on your home when you buy or reduce 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
If you are already a home owner
For example, Sophie has a $500,000 home loan which she took out 2 years ago and has saved the purchase price of a new Hyundai i30 ($29,575 on the road).
She has a choice;
- She can borrow the on road cost of the car (using the 6% rate assumed by the RACV) and use her cash to reduce her home loan.
- Or she can pay the on road cost to the dealer from her savings. Either way her total borrowings are the same.
The interest rate on a car loan is usually a little higher than home loan rates. Sophie’s home loan is at 3.89%.
If she takes the car loan, she will pay a total of $4,731 in interest over the five year period and by paying $29,575 off her home loan she will save $49,230 in home loan interest over the remaining life of her loan (and pay it off 3 years earlier).
By 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, so that you pay less interest overall.
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 $79,575. She could choose to either use $29,575 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 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 $29,575 and a home loan of $520,425 (total $550,000), she will pay LMI of $8,171.
If on the other hand, she pays cash for the car, she will need a home loan of $550,000 and will be up for $20,790 in LMI. That’s $12,619 more – almost half 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.
The right loan matters
Of course, you still need to choose the right car loan. I’ve seen people pay interest rates of 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.
But 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 is to be repaid. Interest rates for car loans under these circumstances are usually higher.
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With over 25 years in Financial Services from consulting to management, Vince Scully is the go-to guy for wealth management and financial advice. Vince founded the Calliva Group; a fund manager, product issuer, advisor and lender to Government and private clients. Vince is an advisor to the Wealth Management Industry, and prior to his role as CEO at Calliva, a senior member of Macquarie bank’s infrastructure team.