You need a new car. You’ve decided to buy one since leasing is a bad idea. Should you pay cash for it? Or should you finance it?
As always, you’ll the crowds militantly on each side of the spectrum.
Which is right in the real world?
I’m not going to tell you what to think (well, maybe a little bit). I’m going to teach you how to think about it. Let’s walk through some principles for applying wisdom to this decision.
Principle 1: Luxuries come last
Too many people buy cars when they are broke. For example, a person may have:
- No emergency fund
- No savings
- No investments
- A $30,000 car
Basic transportation is a need. You need to get to work. You need to run errands. These are true. But a $5,000 car will get you where you need to go. So will public transit. Transportation is a need, but new(ish) transportation is not.
You don’t need that $40,000 car. Or that $30,000, $20,000, or even $10,000 car. Anything over the basic Point-A-to-B are wants or luxuries on top of the need. And luxuries come last.
You need an emergency fund, the proper insurance, and an adequate amount going toward retirement before you stack luxuries on top of your needs.
Principle 2: Only buy a vehicle that you could pay for in cash.
Being able to “afford” a financed car payment doesn’t mean you can afford the car.
If you are financing that $20,000 or $50,000 vehicle because you’ve calculated that you can “afford” the payment but have no money, you can’t afford it.
If you have $5,000 that you could put toward a car, the wisest thing you can do is buy only a $5,000 car. Then keep saving. Sell that car for $3,000 and add another $5,000 to buy an $8,000 car. Work your way up from there. Perhaps you start (or started) with a car that’s 20 years old. Then every five years, you buy a car that’s eight years newer than the last one. Eventually, you’ll have the newer nicer cars in a wise way.
This will keep you from overspending on vehicles as most people do.
Suppose, though, that you do have the cash for the car you want. You’ve determined that $20,000 is the price you’re willing to pay for a vehicle that aligns with your values. You could get $20,000 in cash and pay cash for a car. Should you?
Principle 3: Debt is Risk
If you choose to finance a car, you are undertaking risk. You must make the payment on that vehicle, even if your life changes.
Many people forget this when they advocate financing a car at 5% and investing the $20,000 to make 10%. Then Murphy’s law kicks in. You lose your job, the car needs repairs, and the market is down all at the same time. And you still must make that payment.
When everything works, leveraging debt to invest works. How often does everything work?
Keep this in mind as you think about paying cash vs. financing.
Principle 4: It’s All Connected
If there is one thing comprehensive financial planning teaches you, it is that it is all connected. No financial decision is made in a vacuum. It’s not just cash vs. credit. What about taxes? What about market cycles? What about retirement savings or income?
Just because you can pay for it in cash doesn’t mean you should. Just because you can finance it doesn’t mean you should.
Where is the market cycle? Perhaps you’re looking to buy right now when the market is down from its all-time high, and you have the cash. Depending on your appetite for risk, you might consider financing the car at 4 or 5% and investing the cash in the dip. When the market recovers the 20%+, you could always pull it out at that time and pay off the loan. Annualized returns as measured from a dip are usually higher than long-term annualized returns.
But if you were looking to buy and the market was at an all-time high, perhaps buying in cash would be the better option. The odds are less in your favor at that point.
Or what if you’re retired? Is pulling $30,000 net out of your IRA and paying taxes at your highest marginal rate really the best move? Sure, you’re saving 5% in interest, but if that’s pushing you into a 10% higher taxes bracket, you don’t save anything.
You could maybe pull it from a Roth. But once you take that money out, there’s no getting it back in. Have you looked at what the long-term impact of losing out on that tax-free growth is?
You may be better off financing the vehicle to spread the cost over several years than to take the tax hit.
On the other hand, if you (foolishly) have 50-70% of your portfolio in fixed income, annuities, and cash value life insurance making averaging 2-3% per year, why would you finance a car at 4% or 5%? That’s leverage in the wrong direction: borrowing money to make less than the rate you’re borrowing at.
So the answer, as always, is “it depends.” But these principles do give you some context for how to think about the decision. You can always engage your financial planner in the discussion if you’re not sure about how they are all connected. Any decision involving a lot of money, whatever that means to you, should include their wise counsel.
Personally, I’ve paid cash for vehicles, and I’ve also financed one on a five-year note that I paid off in 8 months due to the cycles that were at play. I’ve advised some clients to pay cash and others to finance. And I’ve advised many that the price they were looking at is too high for their financial position.
It depends. So here are two final principles to leave you with.
Principle 5: When in doubt, pay cash.
More people get into trouble financing than people who pay cash. But…
Principle 6: Get good financial advice so that you’re never in doubt.
This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. RetireMentorship is not affiliated with any Registered Investment Advisor, Broker-Dealer, or other Financial Services Company.