Jimmie wrote in with a good question over the weekend:
I’m going to buy a new car in several months and I’m trying to figure out how much down payment I should have. I’ve heard tons of different answers from different people. What’s your take?
My initial take was to give this an off-the-cuff response – “bigger is better when it comes to down payments” – but then I realized I’d be falling into the same trap of all of the others that gave Jimmie advice. It’s all about the assumptions.
So, let’s walk through a good number of these assumptions and, along the way, figure out a good method for figuring out how much a person should be saving for their car down payment.
Step 1: Get Your Credit Report
The absolute first step you should take when considering a loan is to get your credit report. You can get your credit report for free from the federal government – no strings attached – at AnnualCreditReport.com. I recommend avoiding freecreditreport.com because it requires “enrollment in Triple Advantage,” a credit monitoring service you probably don’t need. Using AnnualCreditReport.com, you can request a report from all three of the agencies – if you’ve never checked your report before, it’s worth it to get all three.
Once you’ve got your credit report(s), read through them and make sure you understand what they’re saying. A credit report is a list of all of the debts you currently owe, as well as all of the credit lines available to you (like credit cards with a zero balance). It also lists any debts that you haven’t paid over the last seven years, including late payments and so on.
Go through this report carefully. Take the time to identify anything on the report that’s false and make an effort to get it corrected by not only contacting the credit reporting agency, but also the company that claims the debt. Get these issues straightened out before you move on.
Why is this so important? Whenever you take out a loan, sign up for a credit card, or get insurance, the company that you’re dealing with takes a peek at this report, which is often summarized for them in the form of a credit score. A credit score is basically just a number that summarizes all of the information in your report – if your report is good, your credit score is high, but if your report is filled with red marks, your score is likely in the trash.
As a rule of thumb, if you have a long credit report (more than two different kinds of debt) and very few negative marks (like late payments), your credit is very good and you’re likely to get a low interest rate on your loan. If your credit report is short, or if you have a handful of dings (more than three, but none of them too severe), you’ll likely get a pretty high rate. If your credit report is trash – with lots of bills turned over to collection agencies and so on – you’ll either get a very bad interest rate on your loan or no loan at all.
There is no exact formula for how your report will affect your credit. Not only is the formula for calculating a credit score not public, but the methods a lender will use to translate that score into a loan aren’t public, either. The best you can do is know your credit report, make sure it’s as clean as possible, and know whether you can expect a good rate or a bad rate.
Step 2: Define Exactly What You’re Buying
The next step is to know what you’re going to buy. Here are some questions to think about.
Are you buying used or new? Buying a new car maximizes the period that you’ll be able to own the car, but during the first few years of ownership, the value of a new car drops like a rock. Buying a used car reduces that period, but also doesn’t cost you in the form of those first few years of rapid depreciation.
The rule of thumb that I’ve always used is that all cars fall 20% in value each year, and a brand new car falls an additional 20% as soon as you drive it off the lot. This is a very rough rule of thumb, but it’s served me very well for getting a thumbnail estimate of the value of a car while looking at cars on the lot using the calculator on my cell phone.
What model are you buying? It’s also a good idea to know the model you’re looking for before you go shopping, or at least have two to three models in mind. This way, you can do the research in advance.
How do I “do the research”? First of all, know what you want for a car. Are you buying a sedan? A compact efficiency car? A SUV? A minivan? Then, hit the library and look through back issues of Consumer Reports and other car magazines to find out what the reviews of models in that general area are and what models are recommended. For example, if you’ve decided on buying a late model used minivan, you’d want to look at the reviews of minivans from three years back, as well as information on the reliability of those models. I generally trust Consumer Reports, but you may want to dig into more sources than that.
Once you know what you’re buying, figure out the value of that car. Use Kelley’s Blue Book to look up the value of the model and year you’re looking at so you have a good idea of what you’re saving for.
Step 3: Figure Out How Much Down Payment You Need
Now that you have all of this information, you’re ready to figure out how much down payment you really need. Follow this decision tree.
Is your credit bad? If it’s bad, you need the biggest down payment possible because you won’t get a good loan no matter what. If it’s good, keep going.
Are you buying new? If you’re buying new, you’ll need at least a 20% down payment on that car, and here’s why. Let’s say you go onto the lot with no down payment, pick out a brand new car, and drive it off the lot. The second you drive off the lot, your car depreciates about 20%. Now, you drive it around for a month and suddenly you lose your job – and you realize you need to sell this expensive new car. The best you’ll probably be able to get for the car is about 80% of the asking price, but if you’ve made no down payment, even selling the car right now will leave you with 20% of your loan unpaid and nothing to show for it. This is called being “upside down” in a car loan, and it’s something to avoid if you can.
On an older car, this effect still exists, but it’s much smaller. You’re in good shape if you can have at least a 10% down payment on that car, because a used car can usually be resold without a major depreciation loss.
What’s the actual best loan offer you can get? Before you go, stop by your local credit union and see what sort of rate they would be willing to give you on the car purchase. Show them your research, tell them what you’re looking for, and tell them you can pay 20% down. If that rate is high – more than, say, 7% – then you should keep saving for a bigger down payment.
The reason is that if the interest rate on the car loan is higher than the interest you’d earn managing the money yourself in savings accounts or investments, it’s not a good deal. According to my observations, the magic number is about 7% – if it’s above that, you’re better off socking away your money for a while longer.
Also, remember that what you have saved for a down payment isn’t necessarily what you have to pay. If you have 40% saved up and can get an astoundingly low interest rate with only paying 20%, you don’t have to cough up that extra 20% – keep it for your emergency fund or for saving for the next car you’ll have to buy.
Here’s what you should do, summed up in one sentence: Have at least a 20% down payment (unless you’re buying an old car, then 10% is the bare minimum), but if the interest rate is over 7%, save for a bigger down payment and wait until you absolutely need the car.
Personally, I believe strongly in avoiding debt and paying cash for everything, but that philosophy doesn’t often reflect the day-to-day reality of most people’s personal finances. So I offer this one little piece of advice: start saving now. Set up an online savings account and have it automatically pull in $20 a week or so from your checking account, and then don’t look at it until you need a new car. Lo and behold, your down payment will be sitting there waiting for you – and the bigger, the better.