One of the biggest financial decisions you can make is whether to pay for a car with cash or take out a loan. There are pros and cons to both options, and the decision ultimately depends on your personal financial situation. In this blog post, we'll discuss some of the key factors to consider when making this decision, including interest rates, opportunity cost, cash flow, depreciation, and credit score. We'll also focus heavily on opportunity cost and provide some stories of ways that the cash could be used otherwise.
Consider the interest rate
One of the biggest factors to consider when deciding whether to pay for a car with cash is the interest rate on a loan. If you can get a low-interest rate on a car loan, it might make more sense to take out a loan and invest the cash elsewhere. However, if the interest rate on a car loan is high, it might be better to pay cash and avoid the interest charges.
Something that is especially important to consider in today's environment where savings accounts are paying something decent is whether your auto loan from a few years ago has a lower rate. If you can get in a loan with a lower rate than a high-yield savings account then TAKE THE LOAN! Make sure to put the extra money that you would have paid for the car, into that high-yield savings account. Then you are guaranteed to earn more in interest in the savings account than it will cost you in terms of the loan. Then if the bank account rate ever goes down, you can just take that money and pay off the loan.
The ability to be debt free is the same as being debt free on paper!
Consider the opportunity cost
The concept of opportunity cost is crucial when making financial decisions. Opportunity cost is the cost of forgoing one opportunity in order to pursue another. In the case of paying for a car with cash, the opportunity cost is the money that could have been invested elsewhere. For example, let's say you have $30,000 saved up to buy a car. If you pay cash for the car, you won't have that $30,000 to invest in the stock market, a rental property, or another investment opportunity. The opportunity cost of paying cash for the car is the potential return on that $30,000 investment.
Examples of opportunity cost
To illustrate the concept of opportunity cost, let's look at a few stories of ways that the cash could be used otherwise:
Investing in the Stock Market: Let's say you have $30,000 saved up to buy a car, and you're considering paying cash for the car. Instead of paying cash, you could invest that $30,000 in the stock market. Over the long term, the stock market has historically provided a return of around 10% per year. If you invested that $30,000 in the stock market and earned a 10% return for 10 years, you would end up with over $77,000. That's a significant return on investment that you would miss out on if you paid cash for the car.
Paying Off High-Interest Debt: If you have high-interest debt, such as credit card debt or a personal loan, it might make more sense to use your cash to pay off that debt rather than paying for a car with cash. For example, let's say you have $30,000 in credit card debt with an interest rate of 18%. If you pay that debt off with your cash, you'll save yourself $5,400 per year in interest charges. That's a significant amount of money that could be put toward other financial goals.
Saving for Retirement: If you're not already maxing out your retirement accounts, using your cash to do so could be a wise move. For example, if you have a 401(k) or IRA, you can contribute up to $26,000 per year (as of 2023). By using your cash to max out your retirement accounts, you'll be setting yourself up for a more comfortable retirement in the future.
Consider your cash flow
Another factor to consider when deciding whether to pay for a car with cash is your cash flow. If paying cash for a car would leave you with little or no cash reserves, it might be better to take out a loan and preserve your cash flow. Having cash reserves is important for emergencies, unexpected expenses, and other financial goals.
You have to consider your emergency fund at this stage. If you are considering tapping your emergency fund for a car, or really for anything then stop! Take a deep breath and don't do it. Leave your emergency fund alone if it is not a true emergency. I trust you to know what a true emergency is. Don't try to give yourself excuses. Because an emergency fund is such an essential foundational element to a healthy financial life.
Consider the depreciation
Another factor to consider when deciding whether to pay for a car with cash is depreciation. Cars typically depreciate in value over time, which means that they lose value as soon as you drive them off the lot. If you pay cash for a car, you'll bear the full brunt of that depreciation. On the other hand, if you take out a loan and make payments over time, you'll spread out the depreciation over a longer period of time.
Cars aren't an investment. They are a liability that most of the time we are left being forced to use. But if there are alternatives to getting around, mainly public transit, then you can avoid the cost of depreciation entirely!
Consider the credit score
Finally, it's important to consider your credit score when deciding whether to pay for a car with cash. If you have good credit, you may be able to qualify for a low-interest car loan, which could make it more advantageous to take out a loan rather than pay cash. Additionally, making on-time payments on a car loan can help improve your credit score over time.
I said this in the podcast episode but make sure that you do not take out an auto loan just for the sake of building credit. If that is something that you want to do, there are ways to do it for free. I would be happy to hop on a call to explain how you can build your credit score for free. But the simple trick is to pay off your credit cards in full and on time every month. Don't carry any balances on your credit cards and you can still build your credit score.
Consider the big picture
Ultimately, the decision of whether to pay for a car with cash or take out a loan depends on your personal financial situation. Factors such as interest rates, opportunity cost, cash flow, depreciation, and credit score all play a role in this decision. While paying cash for a car can provide peace of mind and avoid interest charges, it's important to consider the opportunity cost of the cash that could be invested elsewhere. By weighing all of these factors and considering your long-term financial goals, you can make the best decision for your financial situation.
Money Talk with Skyler Fleming
Read more at skylerfleming.com/blog
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