Recently, I’ve had discussions with several readers about the concept of paying cash versus taking out a loan for medium-sized purchases, such as an automobile. In order to demonstrate how cost-effective it truly is to buying a car with cash rather than taking out a loan, here’s a clear example that you can calculate at home.
Let’s say you just bought your first automobile with a loan. It’s a cheap one with only a small monthly payment, and your plan is to drive it for four years, then replace it with a car that costs $11,000. After the trade in, you’re planning to spend $10,000 on a car in four years.
You have two options here. First, you can just wait until then and buy the car with a 48 month loan. If you get this loan at 8%, the payments will be about $244.13 per month for 48 months. You can run the numbers yourself using the handy auto loan calculator at bankrate.com.
On the other hand, you can start paying for the car now by putting money into a savings account. If you put $188.90 each month into a savings account (which earns a 5.05% APY), you’ll have almost exactly $10,000 (actually, just a few cents over) after 48 months, with which you can buy the car by writing a check instead of taking out the loan.
With the second plan, you literally pay $55.23 less per month by saving up the money and then buying than buying and then paying off the loan.
What if you made a full equivalent payment into the savings account all 48 months? Instead of putting in just $188.90, you put in the $244.13 you’d have to pay for the loan. After 48 months, the account balance would be $12,924.27. You would have an extra $2,924.27! This could either mean a nicer car or a start on the car you would purchase after that.
Simply put, there is no better way to buy a car than to make the payments to yourself first, then write the check to buy the car. It doesn’t matter how good of a negotiator you are or how good of a rate you get, you can’t top a payment that’s 20% less.
Some people will argue that you have to get a car loan or else you’ll never get a car. This is arguably true for the first automobile that you own, but your first automobile should be just good enough to get you back and forth to work for a few years until you can afford to write a check for your next car.