For most young people today, mobility is of utmost importance.
This yearning for freedom and the ability to make their own choices about where and when they want to go often leads them down the road to buying their first car.
This decision often comes after months or years of saving, leading to one of the first major financial decisions of their lives.
Do I pay cash or get a loan to purchase my first car?
The answer to this is more intricate than one would think.
Financial professionals are divided on the best course of action as such decisions base themselves on many variables. There is no correct answer, as a lot depends on personal circumstance, attitude to investment and many other things, including:
• Financing – How much will you have to pay in interest?
• Depreciation of Assets – How much value does the car lose and at what rate?
• Liquidity – Is there a need for having the cash?
• Opportunity Cost – What else could you do with the money?
The case for paying cash:
The benefits of buying a car with cash are obvious. Firstly, you don’t have to pay interest on it.
By paying cash you will also be the owner of the car, meaning it would become a sellable asset with a (depreciated) value that is realisable during hard times if you require liquidity.
On the surface, it makes sense to pay cash if you can afford it (by having enough money in the bank to pay for the car and enough liquidity to cover your emergency fund of up to six months of living expenses). However, even then, this decision is not quite so simple.
The case for taking on financing:
Affordable financing and opportunity cost are the main reasons for not using your hard earned cash to buy that car.
The basic argument is that if the cost of borrowing is low enough, then there is no reason to fund the purchase with cash. In very competitive markets, it is possible to get 0% interest on car loans or at least loans which carry a rate of 4% APR (annual percentage rate) or below.
If you are paying less for your loan than you would be making by keeping your cash in a savings account, then it makes financial sense to take up the loan and keep the cash in the bank as your net benefit is positive; the interest earned on the savings account could be used to pay for the loan interest.
There is also opportunity cost. With a hypothetical interest rate of 4% on a loan, it is possible that taking up the loan and using the $100,000 as a lump sum for investing could yield a better net return.
Warren Buffet has said you should historically look to achieve returns of around 6% to 7% if you invest long term in the stock market. If you are planning on keeping your car for at least five years (and assuming a 5-year car loan term), then the chances are that your money will work harder by being invested which may not be possible through with a lump-sum cash payment for the car.
Likewise, you might also need the lump sum you were going to spend on the car for other tangible life events such as the down payment on a mortgage or a wedding; this relates to considering one’s liquidity needs.
As with every financial decision, the answer is rarely straightforward. It depends on market conditions and your own personal profile. If you can afford to comfortably service a loan with no or low interest rates, then taking financing and using the money to retain your liquid wealth seems like a good idea.
If you have enough money in the bank, want the security of owning your own car outright and interest rates on loans are high, you should consider using your own cash.