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.