Borrowing money for a car is something pretty much everyone does. Mostly this is because the actual cash cost of a car is more than most people have saved up. However, there’s a lot more to it than just borrowing. There’s also the investment factor, and if you’re smart, you can save more money with a car loan than you’d save by paying cash. In this piece, we’ll be looking at what happens when you get a car loan such as those offered by the providers here, versus what would happen if you had paid cash, or if you had instead invested that cash, and still gotten a loan.
Here’s what happens to your money, and why it’s usually best to get a car loan.
Car loans are usually a very straightforward business. You find a car you like, apply for the loan, and are approved – either with or without a deposit. Obviously the greater your deposit is, the more you will save in loan interest, but here’s where things get a little tricky. You see, assuming a modest 8.5% return on a well-managed investment portfolio of £10,000, you’re looking at earing £850 per year, averaged out over the lifetime of that investment. This is of course not accounting for reinvesting that money, or any stock splits that may occur, which would increase the value of your investment.
If you could get a low interest five-year loan for your car, but instead spend cash, you might be losing money.
For example, if you used a low rate £10,000 loan, like one from TESCO, you could get it at about 4.25% interest, assuming you had good credit. That means you could take out a loan, and still be earning the 8.5% yearly return on your investment. In other words the loan would only cost you about £425 per year in actual realised loss. However, because your investment would still be earning money year on year, you wouldn’t be in the red.
You would instead earn about £2,125 in interest over that five-year period. Accounting for the loss of capital you’re be putting into an interest payment, you’re still doing significantly better than any bank interest rates. This lets you save money, while also continuing to earn it. That’s a healthy net gain.
However, if you instead liquidated your investment, and paid the £10,000 directly to the dealership, you’d end up losing quite a bit of money. While you would not have to pay any interest on a loan, you would also not have any return on your money. Worse, you car will depreciate in value as soon as it leaves the car lot, meaning your financial position would immediately be less than it was before purchasing the car.
In terms of interest, you would be losing the entire £850 per year that your investments would otherwise have earned for you. This means that calculating interest over the five years you could have had a car loan and invested your money, you would lose £4,250. As you can see, in this case, and in almost any case where your car loan interest rate is less than the returns you’re getting from investments, paying cash for a car is almost always a bad idea.
The only time you would not want to do get a loan is if you offered your car dealer cash, and they were willing to give you a significant discount. How significant the discount is would be dependent entirely on the value of your investments and the amount the dealer was willing to discount, but in most cases, you’d need more discount than the average dealer will be able to offer. For example, in the case of our £10,000 loan, we would net a return from our investments of £2,125 over a five-year period, or we would suffer a loss of £4,250 by liquidating those investments.
Cash changes things though, but not necessarily for the better. If the dealer would give you a cash discount of £2,000 on your £10,000 purchase, then you would have £2,000 you could still invest. That investment, assuming the same return of 8.5%, would give you £850 at the end of five years. In other words, you’d still be losing £1,275 over what you would have earned if you’d only gotten a loan for your car, instead of paying cash. You’d also be losing the value of your money, as the car depreciates.
Of course, the dealer is not going to tell you this, and neither are the banks. In some cases your cash hurts them by cutting out the middleman. The bank earns no interest, and the dealer has to sharply discount the car price if they’re taking cash. So while many a dealer will take cash, they are always calculating what gives them the best return – not you. This is why there are often better alternatives that can be had for less. Dealers know this, but few are going to tell you.
To put this knowledge to work saving, you’ll need to do your own homework, and then follow up on any loans you’re qualified for. That will let you have a clear view of the big picture. If you have any trouble with it, just remember that as long as your investment is earning more than your loan interest rate, you’ll almost always come out ahead.