#BreakingItDown – What Is The Best Way To Pay For A Car? Car Loan vs Cash
- Buying a car with cash versus taking a loan – which is better?
- Things to consider when weighing in the pros and cons of buying a car with cash versus a car loan
- Other ways to pay for a car besides by cash or an auto loan
- Verdict: Buying a car is expensive, so navigate carefully, especially because its value will depreciate fast
If you are in the privileged position of having enough upfront cash to pay for a car, does it mean that paying for a car via cash, as opposed to financing, is automatically the best way to go?
After all, car loans are notorious for having the reputation of being the single monthly commitment that hinders one from building and growing their wealth.
This perception is not completely far-fetched and has its merits – most car loans are so-called upside-down loans, meaning the amount you owe for your car is more than its market value. This happens because the value of cars depreciates especially with a seven to nine-year loan tenure.
Though it is common for car buyers to rely on financing to purchase a car, do not assume you have to as well— there are plenty of other ways to pay for a car that doesn’t include taking up a loan.
Here is a breakdown of some of the common car payment options to consider, and analysis on which is better: paying via cash versus the loan.
Buying a car with cash versus taking a loan – which is better?
Most people think that buying a car with cash is better than financing because you get to avoid paying interest every month. After all, with cash, you only pay the sticker price, and there are no additional charges as you go through the years.
That is true. However, if the interest rates you earn on your savings or investments is higher than the after-tax cost of borrowing, then you may lose out on growing your wealth if you decide to pay the car in cash.
Tip: Get a loan when interest rates are favourable.
Understandably, some people may want to avoid loans at all costs to avoid having debt hanging over their head.
List down the pros and cons of buying a car with cash versus a loan for more clarity.
Things to consider when weighing in the pros and cons of buying a car with cash versus a car loan
1. The opportunity cost of cash
It’s important to establish that, in addition to the sticker price of a car, the actual overall cost of a car includes the interest you’ll pay on your loan over time.
So if your main focus in life is to remain debt-free, then paying via cash wouldn’t be such a bad idea — if you can afford it.
But, if you pay in cash, there will be an opportunity cost in the future, aka the interest or investment returns via savings or stocks that you could have earned from keeping that cash. In other words, you lose out on capital that could have been used to grow your wealth.
Let us say you have RM20,000 and you want to buy a car costing RM20,000. You can pay via cash, and that means no loan is needed. You also get to protect your budget from a minimum interest rate of 4% to 5% per year.
Alternatively, you could pay your car via a 10% down payment and a 90% nine or seven-year car loan. If you do, that leaves you with RM18,000 cash in hand and a typical RM1000 monthly instalment.
Which is more worth it?
It depends on how you plan to utilise the RM18,000.
You could, for example, earn RM 19,764 or so if you put it into a savings account that comes with a return or Annual Percentage Yield (APY) of 3% monthly, and if you deposit a minimum of RM100 monthly. Check out this calculator we found online to help calculate your APY.
Note: Actual returns on savings and investments are usually higher than 3% but it is hard to predict and is never guaranteed. For instance, you could earn up to 5% in returns on the cash by investing it elsewhere via stocks or ETFs.
However, if you spend that RM20,000 to buy a car, you will automatically forgo those earnings. By the way, if you need a list of dummy-proof ways to invest your money, we recommend you check this article we wrote about investing.
We read that a 7% APY from your savings is a good indicator that you should keep the money and opt for a car loan instead. The return could maybe go up even more significantly when the value compounds over time.
2. Any interest rates below 2% are worth financing
Compare best interest rates from lenders online. Sometimes interest rates are subsidised by auto manufacturers to help sell off cars.
A car loan that comes with an interest rate below 2% is worth it because this figure is typically lesser than investment or savings returns – though there may not be many if any, car loans at that rate.
The goal is to earn and not lose. Let’s say you invest in stock and earn long-term returns equivalent to 8% in annual return and you pay 2% in car loan interest, you are getting 6% on your money, before inflation. That’s not bad at all.
3. Debt service ratio
If you have ever applied for a car, home, or personal loan, you will have heard the phrase ‘Debt Service Ratio’ from the bank’s loan officers when they explain how a loan works.
In short, Debt Service Ratio, or DSR, is a calculation used by banks to check whether you are capable of repaying a loan. Your DSR is usually compared against the bank’s maximum allowable DSR limit. If your DSR is within the limit, you stand a higher chance to receive the loan. However, a DSR limit varies according to individuals and their respective levels of net income.
Calculating your DSR is another way to help you figure out if paying by cash is better than via a car loan, and vice versa.
For example, let’s say you have a housing loan of RM1,000 and a car loan of RM1,000 your total commitment would add up to RM2,000 and you will have a DSR of 40%. As a benchmark, if your DSR rises above 40%, you may want to reconsider buying a car at all, to avoid overspending beyond your means and end up in financial distress.
4. Any plans to take up other commitments?
In the same vein as the previous point, assess whether you plan to sign up for other loans or commitments like buying a property or continuing your education, among other factors because this could affect your overall bottom line.
It’s also important to realise that the value of a car depreciates over time, so really assess whether you have the finances to commit to that monthly instalment. We recommend those looking to buy a property to not carry a car loan at the same time – if possible.
Other ways to pay for a car besides by cash or an auto loan
1. Use your savings
To be honest, it is unrealistic for a person to save enough cash to buy a brand-new car outright. The whole concept of car loans was created to help us buy new cars. Instead, it is a much wiser strategy to pay with cash if you are buying a used car. The added plus of paying with cash is skipping the interest.
The next question after that is to figure out how long you will need to build up the money to buy a car with cash. Start saving from young and set aside at least RM20 every day. In a year, you could save up to RM7,300 and in five years, that will grow to RM36,500. And thanks to the power of compounding interest, over time, you will be able to grow that money even more.
Eventually, you will have a significant sum of money to cover the total cost of a vehicle if not reduce the amount you will need to finance.
2. Try out other borrowing methods like credit cards and personal loans
Paying a car with a credit card may sound like an absurd idea but hear us out. Though we do expect dealerships to have limits on how much they can pay via a credit card, you may try using it to pay your down payment. If it’s possible – as it depends on dealership policies and your credit limit – you could maybe even fund the entire purchase amount with a card. But make sure you contact your card issuer and bank for further clarification first because it requires such a large transaction.
Disclaimer: We are not saying this is the best way or the go-to way – credit card interest rates are typically higher than auto loans. On top of that, carrying a large balance can hurt your credit because you will use up a large portion of your credit utilisation ratio.
Personal loans are similar to auto loans, in that both require a monthly instalment that will come with interest. The big difference, however, is that personal loans are unsecured loans, so what that means is though your asset will not be repossessed if you don’t pay on time, your credit will be severely affected. Besides that, personal loans have typically higher interest rates compared to auto loans.
Borrow from family and friends. This may be the least favourable method because you will need to ask around – but it doesn’t hurt to ask friends or family if they are willing to give you an interest-free loan. This could also be an option if you are short of a couple of thousands. However, we don’t recommend you count on this solution because it can be hard to convince someone to lend you money and we can’t guarantee that all families and friends are willing to provide such support to you either.
Buying a car can be a complicated and tedious process, but it doesn’t have to be a miserable one. So take comfort in knowing that many people have gone through it before you.
If you do end up deciding to get a car loan, search and compare online to get the best interest rates. We wish you good luck!
Whether you are a first-time or seasoned buyer, the process of buying a car can be complicated if you don’t know the industry that well. The #BreakingItDown series is all about addressing this problem. Stay tuned for more content.