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Should I Finance a Car or Pay Cash?

last updated December 2, 2013 by

If you have the money to pay for a car upfront, you might wonder why financing a car should even be an option.  Financing a car comes with additional costs, including interest payments and higher insurance premiums, so it costs more over time than purchasing a car with cash.  On the other hand, even if you can afford a car outright, it might be worth choosing to take out an auto loan for a few different reasons.

Keeping an Emergency Fund

When most people go to pay for a car with cash, they are drawing from their savings account rather than from daily expenses that they have budgeted for.  This reduces their overall financial liquidity, reducing the amount of cash that they have on hand to deal with other expenses that might come up.  There are plenty of possible expenses that MUST be paid in cash, and cannot be financed, such as roof repairs and medical treatments, so if a person spends their emergency fund/savings on an automobile they won’t have the necessary cash to deal with these expenses as well.

It is a good general practice to keep at least six months of your income on hand as an emergency fund at any one time. This would allow you to live comfortably for six months should you lose your job or source of income, and it is also enough to cover unexpected expenses when they pop up.  If buying a car in cash would reduce your emergency fund to lower than this, it might actually make financial sense to finance the car.

Zero Interest Financing Deals

If you have an extremely good credit score (and you probably do, if you are able to pay cash for a car) you might qualify for zero-interest loans at your local car dealership.  These loans are usually given out near the end of a fiscal year when a dealership is facing pressure to increase sales.  Zero-interest loans give you a certain payment period to make the payments on your car without interest before they begin charging.  As long as you are able to pay the loans off in this time, you won’t incur any interest expenses.  In fact, by keeping more of your money in the bank, you are able to continue earning interest and investment returns on your cash before paying off your car at the end of the promotional period.

Auto Loan Interest Rates

Another aspect of auto loans to look at before making your final decision to pay for a car in cash is the interest rate.  As of last year, interest rates were at their lowest point in decades, so taking out a loan could actually make financial sense.   Basically, if interest rates dip below the expected rate of return of your investment portfolio, financing a car is more financially sensible than paying for it in cash.  For example, if you receive an 8% return on your stock investments and a car can be financed at 3% interest, you should withdraw as little money from your stock investment as possible to pay for the car, thus preserving your earning potential.