Cash or credit: The cost of your next car purchase

When you take on a car loan, you’re paying for the privilege of spreading your payments over time. According to the most recent Cox Automotive data, this privilege comes at a premium, with an average interest rate of 9.66% for a new car loan and 14.3% for a used car loan. Interest payments add substantially to your total vehicle cost over the loan’s lifetime.

The hidden costs of cash deals

However, the cash-versus-finance equation isn’t as straightforward as it appears. Paying cash can cost you money in unexpected ways. Manufacturers frequently offer financing incentives that cash buyers miss entirely.

Zero-percent financing deals may make more financial sense than buying with cash, and significant rebates tied to dealer financing and other manufacturer incentives can sometimes exceed the interest you’d pay on a loan.

Savvy consumers have discovered a workaround: Accept the dealer’s financing to capture the incentives, then pay off the loan immediately. Most lenders allow early payoff without penalties, letting you enjoy the best of both worlds -- provided you read the loan terms carefully.

Negotiation strategy that saves money

Here’s where many cash buyers lose money without realizing it: Revealing your payment method too early in negotiations. Some dealerships may not budge from the vehicle’s sticker price when they know you’re paying cash, compensating for lost profits from financing commissions.

The winning strategy? Negotiate the best possible out-the-door price first, then discuss payment options. Tell the salesperson, “I don’t know if I’m going to pay cash or finance this car until I hear all the options.” This approach ensures you compare apples to apples when evaluating your final costs.

Opportunity cost considerations

Paying cash for a car means tying up a significant portion of your liquid assets in a depreciating asset. That $40,000 sitting in your driveway could have been earning returns in the stock market, mutual funds, a high-yield savings account or other investments. If your investment portfolio typically returns 7% to 8% annually, but your car loan costs only 4% to 5%, financing might boost your real net worth over time.

This opportunity cost becomes even more significant when you consider that cars depreciate rapidly -- by about 30% over the first two years, on average. By sinking your cash into your car, you’re trading potentially appreciating assets (investments) for a depreciating one (the vehicle).

Emergency fund protection

Financial advisers consistently recommend maintaining three to six months of expenses in emergency savings. Depleting your cash reserves for a car purchase could leave you vulnerable to unexpected costs. A loan might provide better financial security if your car purchase significantly impacts your emergency fund.

Consider this scenario: You have $50,000 in savings and want to buy a $35,000 car. Paying cash leaves you with only $15,000 for emergencies, possibly forcing you to rely on high-interest credit cards for unexpected expenses. A car loan preserves your financial cushion while spreading the vehicle cost over time.

Credit building benefits

For consumers with limited credit history or those working to improve their credit scores, financing a car provides an opportunity to demonstrate responsible borrowing. Successfully managing an auto loan can boost your credit score, saving you thousands on future mortgages or other major purchases.

This benefit can be significant for young adults or those recovering from financial difficulties. The improved credit score from a well-managed auto loan often results in savings that exceed the loan’s interest costs.

The smart money approach

The most financially savvy consumers don’t choose between cash and financing based on preference. They run the numbers. Calculate the total cost of financing (including interest) versus the opportunity cost of using cash. Factor in manufacturer incentives, your current investment returns and your overall financial situation.

Financing wins if it costs less than 4% to 5%, and you can earn more than that in investments. If a manufacturer offers you zero-percent financing or substantial rebates for financing, those deals often beat paying cash. However, cash might be your best bet if you’re facing high interest rates and have limited investment opportunities.

Making the decision

Before heading to the dealership, determine your maximum comfortable cash outlay and research current financing incentives. Never compromise your emergency fund or retirement savings for a car purchase. If paying cash would strain your finances, financing is the more intelligent choice regardless of interest costs.

The right choice varies by individual circumstances. A retiree with substantial savings might benefit from paying cash, while a young professional building wealth might prefer financing.

Approach this decision with clear financial priorities rather than emotional preferences. Your car is transportation, not an investment. Make the choice that best serves your overall financial health.

Chris Hardesty is a veteran news researcher and editor who provides advice on buying, owning and selling cars for Kelley Blue Book and Autotrader.

The Steering Column is a weekly consumer auto column from Cox Automotive. Cox Automotive and The Atlanta Journal-Constitution are owned by parent company, Atlanta-based Cox Enterprises.