Car loans are ubiquitous in the United States. According to Experian, a credit-reporting agency, about 45% of new cars and a little more than half of used cars purchased in the second quarter of 2018 were financed with loans. But car loans can be detrimental to one’s finances, so avoiding them and paying cash is the wiser choice if you can swing it.
In general, taking on personal debt is ill-advised unless the rate of return you experience if you invest the cash outpaces the loss from interest on the loan. Given the recent stock market boom and low interest rates, car buyers who invest their cash and then take out a loan to purchase a car could realize a net gain. However, there are other costs associated with financing that must be taken into account.
Suppose you have set your sights on a car costing $20,000. A 60-month car loan at the average interest rate of 4.2% will cost you $22,208 over the loan term, according to ValuePenguin. If, however, you invest your $20,000 at a rate of return of 9.8%—the S&P 500’s 90-year average, according to CNBC—you would have $31,918 after 60 months. But these numbers don’t tell the whole story.
First, 4.2% is the average car loan interest rate, but borrowers with low credit scores pay much higher rates. In Indiana, creditors can charge up to 21% interest on auto loans, according to legal resource FindLaw. At those rates, a $20,000 loan would cost $32,464 over 60 months, a loss which would very likely outpace even the best return on investment.
Second, full-coverage insurance—a requirement for those financing a car—costs two times more, on average, than minimum-coverage insurance, according to insurance comparison website The Zebra. In Indiana, the cheapest full-coverage car insurance is $95 per month, while the cheapest minimum-coverage insurance is $36 per month. Extrapolated over the 60-month term of the car loan, you would pay an additional $3,540 in car insurance, eliminating 36% of your return from your alternative investment.
Finally, NerdWallet reports that repair and maintenance costs average $1,188 per year. Even with a typical three-year warranty, you will pay roughly $3,564 out-of-pocket over the final 24 months of a 60-month loan, further reducing your net return from investing. To make matters worse, the Chicago Tribune reports that newer cars can cost twice as much to repair as their older counterparts thanks to modern safety features.
In short, financing a car is not a prudent financial decision for the average consumer. Borrowers with excellent credit and enough cash on hand to cover the cost of the loan may be better off investing the cash and getting the loan, but only during favorable market conditions, which are notoriously difficult to predict long term.
Saving thousands of dollars to purchase a new or used vehicle can seem daunting; however, setting aside a little each month adds up over time. Even if your savings is inadequate to cover the entire cost of a car purchase, it will go a long way to reducing the total car loan and associated expenses.
Ansley Fender is a personal finance coach and freelance writer. She is the owner of Fender Financial Services, a bookkeeping firm for nonprofit organizations and small businesses.