Auto Financing vs. Paying in Cash: What Are the Costs and Benefits?

Sometimes, the old clunker finally goes from “on its last leg” to “broken its last leg.” Other times, that commercial showcasing state-of the-art features entices you into the dealership. Either way, when you’re in the market for a new car, cost is a factor in determining how, when, and what to buy. When reviewing that paper on the car window at the dealership that details terms and buying options, which option is the best? Should you finance the car or just take the big hit all at once and pay for the car in cash? There are costs and benefits associated with each option — here are just a few.

Present versus future costs

The primary benefit of buying a car in cash is the avoidance of finance charges and interest. A $20,000 car costs you only that $20,000 (plus applicable taxes). If you finance that same $20,000 for 60 months at the national average auto loan interest rate of 4.22 percent (according to a recent Bankrate publication), assuming zero taxes and zero down payment, your monthly loan payment would then be around $370. This makes the total cost of that $20,000 car $22,200, an increase of $2,200.

Read more: 5 Simple, But Clever Solutions for Car Conundrums

The cost of financing can increase dramatically if you have average or below-average credit. The higher your interest rate, the greater your payment.

If you have the money on hand to buy a car in cash, the cash option would seem like the optimal choice. However, you could also take that same $20,000 and, instead of buying a car in cash, place that money into a risk-free investment. Even at the current five-year Treasury bill rate of 1.74 percent, the value of that $20,000 five years from now is around $21,800. This opportunity cost of $1,800 is also a considerable factor. Additionally, a car depreciates in value. Investing in a depreciating asset is generally unfavorable.

Depreciation and resale value

It is a commonly known fact that once you drive a new car off of the lot, its value declines. For certain makes and models, depreciation is of greater concern than others. A recent Bankrate publication indicates specific models that see high depreciation over five years. Some of the models that made that list lost around 65 percent of their value after five years. On the other hand, some vehicle models may lose less than 30 percent of their resale value after five years.

Read more: 8 Safe and Sensible New Cars for the Rookie Driver in the Family

Although paying for a vehicle in cash is a large investment in a depreciating asset, the cash option does provide you with the security of knowing you will not end up in an “upside-down” auto loan, in which the amount you owe on the car is greater than the car’s value. Not having to worry about an upside-down loan will be advantageous if you decide to trade in or sell the vehicle.

Building credit

When you finance a car, you are beginning an installment account. According to My FICO, new credit is evaluated to determine 10 percent of your credit score, and types of credit, such as installment accounts, encompass another 10 percent. For an individual that is trying to build credit, financing a car can be beneficial.

Read more: 10 Coolest Cars Under $25,000

Additionally, building rapport with a lender by financing an automobile may offer future benefit. If you seek a loan for a home or business, it helps to go with a lender that has worked with you in the past. When you buy a car in cash, there is no credit transaction, no lenders, and therefore no credit building.

More From Wall St. Cheat Sheet: