By Matt Becker

Posted September 9, 2013

My wife and I just recently went through our first car-buying experience and learned a lot along the way. It was bumpy at times and we definitely made some mistakes, but I think in the end we did enough right to come away with a purchase that fit pretty much everything we were hoping for when we started out.

One of the big benefits of this experience was the knowledge I gained that I can pass on to my readers. Theres a lot that goes into the car-buying process and I hope that my experience can make it easier for you when you have to go through it yourself.

With that in mind, Ive created a car-buying series that will take you through the lessons I learned. Today is Part 2 in that series. You can follow the entire series here:

One of the big questions youll face when buying a car is how you want to pay for it. Will you pay with cash or will you finance?

I think that there are pros and cons to each option, and certain situations that favor one over the other. So today Id like to discuss those variables and explain how we arrived at the decision for ourselves.

Pros and cons of cash vs. financing

The biggest benefit of buying a car with cash is that you dont have to pay any interest. A car is a depreciating asset, meaning its value is constantly dropping. This is in contrast to something like investing in the stock market. where you hope that the value of the asset will grow. Paying interest for something that is losing value means that youre losing money in two directions. In general, this is not a good thing.

Another benefit of buying with cash is that you own the car outright, which simply gives you more options. If you have a loan and you fall on hard financial times, the bank or dealer or whoever loaned you the money can take the car from you if you fail to make your payments. When you own outright, not only are you free from that threat but you also have the option to sell the car if you need some cash like my friend Nick. With a loan, you can still sell but you have to coordinate with the lender and any proceeds first have to go to pay off the loan. You may even owe more than the car is worth, which means selling would actually require you to come up with more money in addition to the sale proceeds.

Finally, paying with cash removes the hassle of having a loan. There are no monthly payments, no dealing with a lender. You write a single check and the car is yours. Free and clear.

The big downside of paying with cash is simply that you have to have the money. Cars can cost a lot and not everyone has that much cash on hand. Of course in that case I would strongly encourage re-evaluating how much you want to spend on a car. Theres a lot of good advice out there on how to buy a well-used car on the cheap. But if theres some reason you need a more expensive car and you dont have the cash on hand, financing might allow you to get it, albeit with the costs above.

Theres also an opportunity cost to paying with cash. Any money you use to buy a car is then not available for other things. The cost here depends very much on what you would be using that money for otherwise, and Ill get into some more detail about this below. When you finance, you are paying interest but the money not yet put into the car is available for other purposes.

When might it make sense to finance?

The only circumstance in which it can make financial sense to finance is when you have the cash available to pay for the car you want, but you feel like you can find a use for that money that is worth paying the interest on the auto loan. I think it can make sense to finance if all of the following conditions are met :

1. You have a full Stage 2 emergency fund. and
2. You are able to secure a low interest rate on your loan (about 0-2%)

and either:

1. The full difference in up-front cost between paying cash and borrowing will be invested for the long-term. or
2. You want the difference in up-front cost available for another big near-term purchase (e.g. other car or home)

A full Stage 2 emergency fund. with 3-6 months of expenses in savings, will allow you to either handle the payments or even pay off the loan if you hit a difficult financial stretch. It provides some security to balance out the risk youre taking on by borrowing.

In order for financing to make sense, you have to secure a low interest rate loan. Once you start paying more than 2% or so, it can become pretty dubious whether the cost is actually worth it.

Finally, you cant just take the loan and be done with it. You have to do something with the money youre saving up front by taking a loan or the cost in interest is a waste. Lets say that the car you want would cost $20,000 but you could choose to finance it with a $5,000 down payment. The only way financing could really make sense is if you actually have the $20,000, but you take the $15,000 you save up front and do something productive with it. If you just spend it, or if you never had it in the first place, youre basically lighting that money plus the money going towards future interest payments on fire.

So what could you do with that $15,000, or whatever the amount is in your case? The first option given above is to invest it for a long-term goal. such as retirement. With a balanced investment plan you should be able to expect somewhere around 6-8% in long-term returns. When compared to a 0-2% interest rate on the loan, those returns can be worth it, but only if the money is truly invested for the long-term. Short-term returns could easily be much worse than that given the risk involved with investing in the stock market .

The other option would be to keep the money available for another big near-term purchase. Lets say that you need to buy a car now but you also want to purchase a home in the next year or two. Financing the car could leave you with more cash in savings to put towards the down payment on the house. This is not really a financially sound move, since youre buying more things than you can afford, but if you have a solid long-term plan surrounding this decision then I could see it being a reasonable decision.

What if you dont have enough cash for the car you want?

If you dont have enough cash to pay for the car you want in full, meaning you couldnt follow through with either of the options above, then you have two sound financial choices:

1. Find a cheaper car, or
2. Wait to buy until you save more money

Look, if you cant afford the car you want then financing is just a bad financial decision. Youre paying interest for something you cant afford that is losing value every single day you have it. Its no different from buying a microwave or a cell phone on your credit card and letting the purchase accumulate interest. Its money spent that you will never get back.

If you truly need a car (Im talking real need here, not just a strong want), and you dont have the cash, then find the absolute cheapest car you can that will work and finance as little of it as possible. Youll still be paying interest on a depreciating asset, but you wont have compounded the issue by buying more car than you need. Again, theres lots of good advice out there for how to buy a well-used car. Get what you need with as little financial damage as possible.

Finally, do not raid your emergency fund to purchase a car unless your need is truly an emergency. As in you need a car within the next couple of days and you have no short-term alternatives. That money is there for emergencies, not for purchasing things that cost you money, like cars.

Our decision

As I mentioned in Part 1: Setting a Budget and a Timeline. we have a savings account that weve designated as kind of a mixed car/house down payment fund. I mentioned that our ideal spend amount for our car purchase was about half of that savings account, but that we were prepared to spend up to the full amount in that account if necessary. We would not go above that amount.

Since that money was either going to be used for our car purchase or for another big purchase in the near future, the option of financing and then investing the difference for the long-term was out of the picture. So if we did finance, it would only be out of the desire to have some of the savings available to us for purchasing a house in the near future. Though we didnt like the prospect of using all of our savings, and were going into the process with the goal of not doing so, we decided that no matter what we would pay for the car in full with cash rather than take out a loan. The cost in interest just wasnt worth it to us.

Conclusions

There are certain circumstances where it can make financial sense to finance, but those are rare. In most cases it will make the most financial sense to pay cash, even if it means buying a lesser car than you would like. Just remember that if youre not doing something productive with the money you save up-front by financing, you are simply spending more money and putting your real goals further out of reach.

If youd like to read another take on this subject, you can head over to Debt Roundup for Graysons thoughts on when you should finance a vehicle .