Auto Loans and the Importance of Money Down
After buying a house, for many people the second largest and most complicated financial transactions they will experience is acquiring a car, in make no difference whether the car is new, used, budget, luxury, very basic, or loaded with options. Despite the lesser amount of money involved in buying a car as opposed to buying a house, the considerations are just as many and can be just as complicated—in fact in a certain sense buying a car can be more difficult to understand due to the unique nature of vehicles being both expensive and yet poor holders of investment value.
Let us assume for the moment that, given your unique situation in terms of factors like your income, how you use your car, your age, and your credit history, you have already gone through some of your options and you are sure of two things: you want to buy rather than lease your vehicle, but you can not afford to pay cash so you need a loan; and your situation leaves open the possibility of going for a no-money-down loan or a traditional 20%-down loan. Is this situation the only question that really matters is, “Is it more or less beneficial for me over the life of this vehicle if I put a 20% down payment now and make smaller monthly loan payments, or if I take the no-money-up-front approach and have to make larger monthly loan payments?”
Since many of the contributing factors to this question have to be ignored so as to make the advice as generally applicable as possible, it cannot be overstated that the answer will greatly depend on the buyer’s unique situation. If you work in a precarious industry and there is a very real possibility you could lose your revenue stream for an extended period, the smaller monthly payments and lesser long-term costs associated with putting the 20% down up front makes that option much more attractive. On the opposite side of the spectrum, if you work in a growth industry in which you are virtually guaranteed a paycheck for the foreseeable future, those higher monthly loan payments could allow you to invest that nest egg you have been saving into something that can appreciate in value and/or generate a return, such as stocks, bonds, real estate, etc.
One of the most important factors to consider when you are trying to decide between these two options is what is going to happen to the value of your vehicle. A new car driven off the lot sometimes loses roughly 20% of its value immediately after it leaves the dealership, so one way to look at that 20% down payment is that you are paying for the vehicle’s depreciation ahead of time and saving on interest in the long term. Why is this important? Because as soon as the depreciation kicks in when the car is purchased and driven away, a fully-financed vehicle loan becomes “upside down” or “under water.” What this means is that the owner of the car is now in the position of owing more on the loan than the vehicle is worth. This is a very dangerous place to be in if your financial situation is less than ideal because if your vehicle is stolen or destroyed in a wreck, your insurance company is only going to pay you the actual cash value (ACV) of the vehicle. Thanks to depreciation this discrepancy between what you paid to purchase the vehicle and what the insurance company gives you as compensation for the loss of the vehicle leaves you with approximately 20% less than what you just borrowed to pay for the vehicle. Make no mistake: you are on the hook for this difference unless you planned ahead by purchasing guaranteed asset protection (GAP) insurance. The loan does not go away simply because your vehicle has.
This problem also arises if you want to sell or trade in your vehicle for a new one within the first couple years, when the effects of depreciation are the most immediate and drastic. If you wanted to sell your car before the loan is paid off, you would bank on the value of the car you are trading in helping to offset the cost of the new vehicle, but if you are still in the period when the effects of depreciation are most keenly felt then this can actually work against you. For instance if your car is worth $8,000 but you still owe $10,000 on the original loan, that leaves you with $2,000 of negative equity that will count against you rather than for you, meaning you would have to pay an extra $2,000 for them to take your trade-in and its associated loan off your hands.