It is cheaper to pay cash. But many auto dealers (who make money on car loans) have come up with a clever, computerized gimmick to bamboozle customers into thinking that loans are a better deal.
For example, say you have $10,000. You can put it into a certificate of deposit earning 6 percent interest or use it toward buying a new car. The dealer may argue that it is smarter to choose the CD and take out an 8.5 percent auto loan.
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Here is the dealer’s four step “proof”:
- If you leave you $10,000 in the bank for 4 years, you will earn $2,712 in interest, pretax.
- A 4 year, $10,000 auto loan will cost $1,832 in interest (the interest is less than you think because it is paid on a declining balance).
- So by keeping the CD and taking the loan, you are $880 ahead. (You are only $121 ahead after federal taxes in the 28 percent bracket, but the loan may still look good to people who hate to part with savings.)
- Furthermore, the dealer croons, debtors do even better when the loan’s term is up. Say the car is worth $5,000 from the trade in. That is all the cash the buyer has in hand. But the borrower supposedly gets an amazing $15,880 adding together $5,000 from the trade in, the $880 gain interest, plus the $10,000 still in the bank.
Before you decide that the road to riches is paved with auto loans, sit back and think a minute. There is something the dealer overlooked. Where does the money come from to repay the loan?
If you take the monthly payments out of your bank account, your savings will be wiped out before the loan is entirely repaid.
If you make the monthly payments out of earnings, you will be giving up $11,832 that you could have saved or invested. Either way, the loan costs you more.
So pay cash. Then take the equivalent of the monthly payment, which you are not spending on the auto loan, and use it to replenish your savings. At the end of the term, you will or have your car and more than $10,000 back.
I would vote for the loan only if your fat savings account was a windfall a gift, an inheritance, a winning lottery ticket that you would never be able to replace.