Should you Finance your Car?
By Mack Bekeza, CFP®
Thinking about buying a new car…or at least a car that is new to you? Should you even finance a car purchase in the first place?
This question has been a hot topic for a long time and for good reason, car buying is fun, especially if you have your eyes on a nice car. You know what I am talking about, something with a V8 and has all of the tech and comforts one can ask for. Or maybe if you are a rocky mountain enthusiast like myself, you imagine how easy it will be to get to a trailhead or go for an off-road excursion with a new Toyota Tacoma or Jeep Wrangler.
So with that being said, is financing your car the only feasible way to buy a car?
MoneyMack’s view on financing cars
In short, financing a depreciating asset like a car highly depends on what your financial picture looks like.
For most peoples’ situations, I side with David Ramsey when it comes to car purchases, if you have the means to save and purchase a car with cash and keep that car for as long as possible, I prefer that over financing.
When financing a car, you lose money in two notable ways, a new will car will typically depreciate by 40-60% within the first five years after purchasing it, and after accounting for interest payments, you will pay significantly more over time financing a car opposed to buying with 100% cash. In addition to this, many people tend to buy cars that are way out of their actual budget, which amplifies these losses substantially. Just because a car salesman tells you that you are able to purchase a brand new car with a 60-84 month note and the monthly payment equals or is greater than 20% of your disposable income, that does not mean that is a sound financial decision. In fact, that is never a sound financial decision in my opinion.
However, if you are someone that does not have high-interest debt (such as credit card debt) and figured out that a four-year car loan payment (plus insurance) will be less than 10% of your disposable income, financing a new car might not be out of the question, particularly if you plan on having that car for as long as possible. This is especially true if you have assets that have a higher expected return than the interest rate of a car note, or even better can make up for the car’s depreciation in value over time. You should not allow depreciating assets to dampen your Net Worth.
So with my views on car financing out of the way, what should someone ask themselves about financing a car?
What is my budget?
When it comes to how much car you can purchase, the rule of thumb here is that you should not spend more than 35% of your gross income on a car, this includes applicable taxes and fees. And remember, I recommend that your payment on a 4-year note (plus insurance) should not exceed 10% of your gross income.
Who are you going to finance this car through?
Who you finance through is a critical question because slight differences in interest rates can either lead to great savings or cause you to throw unnecessary money down the drain. I personally recommend that you seek financing outside of your car dealer for two reasons, you will be able to negotiate as a cash buyer (which typically means you can reach the best deal when car buying) and you will be able to shop interest rates and banks beforehand rather than having to make a decision at the dealership (although you can always have a car be put on hold if you need to think a car purchase through). On top of that, Credit Unions tend to be the best choice in terms of car loans since they tend to offer lower interest rates than a typical bank would.
How much should I save for a down payment?
The rule of thumb is you should be able to put down at least 20% on a car. Since new cars depreciate rapidly during the first 5 years, this will mitigate the chance of you being underwater on a car note (although not guaranteed) and your payments will be significantly lower opposed to putting little to no money down. Since the car purchase should not exceed 35% of your income, a 20% down payment should only take a few months to save up.
What is my credit score?
Having a good credit score (720 +) is important to have for two reasons, you will have more options in terms of how you can finance the car and you will be able to lock in a lower interest rate.
How much will my insurance payment be?
One of the main ownership costs of car ownership is auto insurance. Before you purchase a car, I highly recommend that you contact your auto insurance provider for a quote on the car you have your eyes on.
What is the gas mileage like?
Is this car a gas guzzler? Don’t let high fuel costs get in the way of your budget!
What are other ownership costs?
Other than auto insurance, gas, depreciation there are a few other ownership costs you should consider.
- Registration fees and taxes (check to see how your state’s DMV calculates these fees before buying a car)
How many miles are on the car?
If you are buying a new car, mileage will not be an issue since you are the first owner but I always suggest you research when your car will likely run into issues once it hits a certain mileage. Sports cars and other luxury vehicles tend to run to mechanical issues sooner than a pickup truck or commuter sedan would.
How do you intend on using this car?
If you plan on taking this new car offroading or towing a boat/trailer? Does your area experience all sorts of weather conditions, like Denver? This goes without saying but only research cars that are known to withstand what you are planning to use it for.
Do I really need to buy the latest model?
Since brand new cars depreciate at a faster rate than a used car and they are the most expensive to purchase, I steer away from brand new cars and go for something that is at least 4 years old and well cared for. Ideally, find a car that is “certified pre-owned.”
How strong is the manufacturer’s standard warranty?
Not to be confused with an extended warranty that a dealer will offer, having a solid warranty from the manufacturer can be a lifesaver when buying a new car, or at least a new car to you.
How safe is this car and how does it compare to similar cars?
Just because a new car looks cool and fits your needs, it does not necessarily mean that it is not a rolling death trap if you get into an accident. The National Highway Traffic Safety Administration (NHTSA) is an excellent source to research how safe a car is. Kelly Blue Books and Edmunds are also great sources for researching car safety and anything else related to car buying.
What is the potential resale value of the car?
The resale value of a car tells you two things
- How fast depreciation will eat up the value of your car
- How reliable it truly is, cars with lower resale values tend to not be as reliable. Anyone who owned a Range Rover will attest to this.