Buying A Car: How Much Down Payment Is Useful?

A reader wrote to me recently asking the simple question “How much of a down payment should you put on a new vehicle?” The thumbnail answer is as much as you can, but let’s go down the rabbit hole a bit and see how deep it goes.

Using a simple auto loan calculator, you can really see these ideas in action.

First of all, a down payment is an indication to a lender that you’re serious about buying this car. You have some financial wherewithal and you aren’t planning on defaulting on the loan if you have cash involved. In a nutshell, the larger your down payment, the lower the interest rate on your loan is likely to be. Fire up that calculator and try out a loan of your own imagination, then drop the interest rate by 0.5% and notice how the monthly payment drops. A larger down payment can cause that interest rate decline.

Second, a larger down payment reduces the size of your monthly payments. This means a smaller constant drain on your budget over the life of the loan. Fire up that calculator again, but this time reduce the amount that you’ll borrow. You’ll again notice a lower monthly payment.

Third, a larger down payment means interest works in your favor more than before. Let’s say you build up that down payment in a savings account that earns 5% annual interest. While you’re saving up, the account is actually helping you by adding cash to your balance. For example, putting in $100 a month for two years leaves you with $2,518.59 in the account, an extra $118.59 that you didn’t have before. That extra $118.59 will be a reduction in your principal on the car loan, which means you’ll pay less in interest over the life of the loan.

So, how much should you save for a down payment? Generally, I encourage people to have at least a 20% down payment when making a car purchase, and anything above that is good as well. For example, on a $20,000 car loan at 6% interest over five years, every 1% of down payment is worth $3.87 less on your monthly payment and an overall interest savings over the life of the loan of $32.20. This, of course, assumes that the increase in down payment means no change in interest rate – a higher down payment will reduce your interest rate, depending on the offering from your lender. It also doesn’t take into account that some of your down payment is actually interest earnings if you’ve been saving it up over time (as most people will do).

In a nutshell, save as much as you can, make a nice down payment that gets you a lower interest rate, and you’ll be money ahead.

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  1. MillionDollarJourney.com says:

    How about saving enough down payment so that you can buy a reliable used car for cash. :)

    FT

  2. I am with Million Dollar Journey. 100% down for a decent used car 2-5 years old.

  3. Adam says:

    I also agree. While I have a car payment, my wife and I have agreed that–barring complete emergency–this is the last one.

    We also will NOT buy a new car again, unless someone reading this wants to give us $20000 for one!

  4. Trent Trent says:

    I’m following the same philosophy and paying cash for our next vehicle (likely a minivan). Basically, the more cash you can pay up front, the better off you are, as far as I can tell.

  5. mitchell says:

    trent,

    i’m actually in the process of buying a new car, and i was wondering on your thoughts of promotional financing offers.

    for example, i’m going to be hitting up the nissan promotional deal for 2.9% APR over 60 months. i’m getting 5.05% in my savings account.

    what are your thoughts on putting down an extra large lump sum given this information? i mean, i have enough to pay the car off in part or in full, but would it even be worth it given the rate?

  6. cami says:

    I think that saving up so that you can pay cash for a car is great, but everyone has to start somewhere. This is good information for recent college grads and others who are just starting out and don’t want to get themselves too much into debt. Something to consider is, if your down payment is a small percentage of the car you want to buy, it might be a good idea to look for less car, especially if you’ve been saving diligently.

  7. shawn says:

    for example, i’m going to be hitting up the nissan promotional deal for 2.9% APR over 60 months. i’m getting 5.05% in my savings account.

    what are your thoughts on putting down an extra large lump sum given this information? i mean, i have enough to pay the car off in part or in full, but would it even be worth it given the rate?

    As Dave Ramsey is fond of saying if you’re car was paid for would you borrow against it to put the money in a savings account? After taxes you’re going to only be making about 3.6-3.8% on your savings so you’re talking about making less than 1%. That doesn’t take into account the massive depreciation that you’re going to take on the car in the first year. If you have the cash go buy a 2-3 year old car.

  8. Kim says:

    Trent,
    I have a question about cars, I am way bottom up in a Suburban that I shouldn’t have bought, I have a few more years left on the loan, I want to trade it for another cheaper vehicle so I can lower my payments. I really don’t have any money saved up to do this. Should I just keep it and wait until I can save something up for a trade or try to sell it, I have been and looked it seems as every dealership thinks I am about 9,000 in the whole

  9. !wanda says:

    There was an interesting discussion about financing cars at Get Rich Slowly. Let’s say that I’m 23yrs old. I’ve had a credit card for 7yrs that I’ve always paid off in full every month and have never had any other debt. If I have the cash in hand to buy a car, should I take on a small amount of debt anyway to improve my credit rating? (Let’s say I pay a large down payment and do something like pay the loan off in full after a few months.) How do I find out whether it would make sense for me to do that?

  10. Ryan says:

    I don’t think using arbitrage to take advantage of a ~1%/year difference is really worth the trouble. If you think it is, make sure that money is earmarked in its own savings account or CD ladder so you don’t end up spending it.

  11. Kiesa says:

    I wouldn’t be surprised if usually the interest rate is usally lower if you have a higher down payment but not always. For the last vehicle my husband and I bought (used), we had enough money to pay about 1/2 the cost of the car. However, our lender (not the car dealership) told us that if we financed most of the cost of the car we could get the “new car” rate instead (the difference was at least .5% — maybe more I don’t remember). So we went ahead and paid a very small down payment and then within the first month paid about 1/2 of the loan. Seems kind of weird to me but we didn’t run into any unexpected problems as a result . . .

  12. vesulius says:

    Don’t forget that a higher down-payment can make a huge difference with the depreciation gap and insurance.

    Say I buy a car for $20,000 and put $2,000 down. I owe $18,000. The minute I drive it off the lot, it depreciates by $4,000, so now is worth only $16,000. I have a $2,000 gap in what I owe versus what its worth.

    If, on my way home, I get hit by someone else, insurance will only pay the value of the car–not the payoff amount! So I get a check a couple of days later for $16,000–but that doesn’t pay off the entire loan. I still have to pay $2,000, out of my own pocket with no car to show for it.

    You can, of course, buy gap insurance, but it is expensive and wouldn’t be necessary if you’d put down enough money that you never owe more than the car is worth.

    V

  13. Tim says:

    Trent, normally i agree with many of your posts, but your rational seems highly flawed in this one.

    1. a car dealer could care less about a down payment. having a down payment does nothing, because at the end of the day whether you get a loan or pay in cash, the dealer is getting the money. moreover, you should already be going in to a dealership with payment already worked out. it makes a deal more attractive on the dealer’s terms, b/c he can try to sell you something based off of monthly payment versus what you should have already researched you can afford and are willing to pay. a dealer sees you as being serious if you have financing or payment option already established prior to arriving at the dealership.

    2. yes, a down payment reduces your monthly payment, but you should have already figured out what you can afford in the first place. this seems backwards logic, much like the car dealership uses when negotiating with you–that is, they ask how much do you want your monthly payment to be. when negotiating for a car, never base it off of monthly payments. do the homework first before going so you know what your monthly payments will be and what you can afford. this is again why you should have financing arranged prior to going to the dealership.

    3. your interest is in your favor point didn’t take into account the down payment money earning interest versus the lowered loan payments. you definitely need to do a comparison that includes this.

    Kim, regarding the suburban. do not go upside down on it. if you are not at the break even point, you should keep making the payments and try to see about making larger payments to get to this point. you will get more by trying to sell it privately than trading it in. take a look at your figures and determine if it will work. try selling it on craigslist or something else first to see what people are willing to offer you in your market. if it is break even or more than do it for the purpose of getting something more affordable. don’t forget to call your loan company to see what the real payoff amount is. most will not have early payoff penalty and only include interest up to the current pay off date. so look at your contract and ask the question. it also seems you went into the dealership without doing research on the value of your car. this puts you at a serious disadvantage when trying to negotiate terms for trade-in. if the dealership is saying $9k, I’d say it is more likely around $3-$4k upside down. but that is just guessing on my part not knowing your current loan terms and how many payments you have remaining. in general, you should be at break even point about 2.5-3.5 years into a 5 year loan.

    right now the big three are reverting to 0% financing again, so if you are in the market for a big 3 car and eligible for 0%, then i’d say jump on it now.

  14. MVP says:

    We’ll NEVER finance another vehicle. We’ll manage with our two 11-year-old cars ’til we save up enough to replace whichever one dies first with a low-mileage car that’s within about 5 years old. After having been a slave to debt for too long, and digging ourselves out of it (to the tune of $41K), it would just hurt too badly psychologically and financially to start making car payments again. There’s just no reason to. I’d much rather put our money toward more imortant things than new, fancy cars and interest payments.

  15. Cibu says:

    I was wondering… What if you come into a lump sum of money after your car loan has been setup. How does it affect the loan if you pay more than the amount that you are supposed to pay at once. Lets say out of a $40,000 car you end up with a loan for 3 years and a payment of around $800, but then 2 months into the loan you find that you can readjust your spending habits and actually pay somewhere close to $1,000. Can you pay $1,000 monthly and make a difference to the total you pay?

  16. James Starch says:

    I think the best thing to do is put all your money in a mutual fund, there is a good one i know, guarrantee 12% a year, it’s the Madoff fund, i have 45% of my paycheck going in it, it so good i have stop looking at my statemment, i must be close to having a $1000000 by now. when you have saved about $10000 in the Madoff fund get a $10000 payday loan and buy the car for cash.

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