Is Buying a New Car For Zero Percent Interest Loan a Good Idea?

by Joe Plemon on August 2, 2012

My friend Larry recently asked me a good question that led to a challenging question: “Joe, isn’t it true that everyone needs to be putting aside money every month for a car fund?”

Joe, “Well, yes. Although some may be wealthy enough to have a nest egg generating vehicle purchase money, the vast majority of us need to be constantly saving for our next car purchase.”

Larry, “I know you are big about saving for car purchases. But I have been able to get a zero percent loan on the last couple of new cars I bought, so what is the difference in borrowing at zero percent and saving up to pay cash?” (That was the challenging question)
I admit that Larry caught me off guard. He is a sharp guy who would immediately challenge any noble idealism I might purport about debt being bad. He needed objective rationale.

Buying a new car and getting a loanSo, scrambling a bit, here was my response, “Larry, I have found that when I save and pay cash, I am much more selective about what I buy. That cash is something that I have worked and scrimped to save, so I shop very carefully. On the other hand, when I borrow money to buy a car, I don’t see the money come out of my account, so it just doesn’t seem as real. I will therefore pay more, buy newer and get more options. In short, I spend more when I borrow than I would paying cash.”

“Oh. I hadn’t thought of it that way.” Larry was slowly nodding his head. “That makes sense.”

So I suppose I was able to give a decent answer, but Larry’s question made me think. Are there other reasons not to borrow money for a new car, even at zero percent interest? I think there are. Here are some thoughts:

Depreciation

New cars depreciate faster than used cars. Yes, you get a new car guarantee and a new car smell, but you are paying for it. According to SafeCarGuide.com,  “New cars lose an average of 20% of their value the instant they are driven away from the dealership. When coupled to the annual yearly depreciation of 7% to 12%, your first year’s loss is anywhere from 25% to 35%. That translates to a loss of $6,000 to $8,000 loss on a $22,500 new vehicle, or a $10,000 to $15,000 loss on a $40,000 one. And that is for a vehicle that is only driven the average of 13,500 miles. If you drive more than that, your depreciation will be greater (35% to 50% for the first year)”

I think you get the point. That zero percent loan is costing you between $500 and $1,000 a month in depreciation costs for the first year alone.

Risk

The zero percent loan could spellbind you into buying too much car. If life happens (injury, job lay off, etc.) and you can’t make your payments, Mr. Tow Truck will show up and get your car. You will still owe on the negative equity even if you no longer own the car. Zero interest sounds pretty hollow once repo man shows up.

May be paying more for car

You may well be paying for that zero interest loan via higher sale price. Yes, dealers are offering deals to move new cars, but they aren’t stupid. That same car might have sold at a lower price if the financing would have included some interest payment.

The cost of dealing with a dealer

New cars, of course, must be purchased from dealers, but that is part of the problem. For sake of discussion, I compared the Kelly Blue Book retail price of a 2007 Cadillac Escalade ESV, excellent condition, with the private party price of exactly the same vehicle. The retail price of $42,440 is $3,600 more than the private party price of $38,840. My point is that you pay a premium simply for buying from a dealer. You also pay more sales taxes in many states. For example, in Illinois (where I live) the taxes for that $42,440 vehicle purchased from a dealer are $2,652.50 compared to $1,500 if purchased from an individual.

Lost opportunity cost

Larry and I started this conversation by agreeing that everyone, whether they are making payment on a loan or saving to pay cash, needs to budget a set amount for vehicle purchases. Even at zero percent interest, the new car buyer is going to pay more per month than someone (like me) who saves up and pays cash. How much is this difference and what could that money be doing if it weren’t going for cars? This number will vary greatly from person to person, but if we assume a $25,000 new car every five years compared to a $10,000 used car every five years, and factor in depreciation for each, the new car buyer will pay about $220 a month more. The lost opportunity, if invested at 8% annual growth for 40 years, is $768,000 dollars!  How many of us could use that much extra cushion in our retirement portfolios?

Concluding thoughts

While a zero percent loan on a new car sounds good, there are many downsides. If the owner buys a new car just to get that zero percent loan, he is probably buying more car than he would by saving and paying cash. Even though he isn’t paying any interest, he is paying for depreciation, sometimes as much as $1,000 a month for the first year. Other downsides are risk and the higher costs of purchasing from a dealer. In addition, the lost opportunity cost can be substantial over a lifetime.

According to “The Millionaire Next Door” by Stanley and Danko, 37% of millionaires buy used cars instead of new. Hmmm. Maybe that is how they became millionaires.

How do you plan for car purchases?  Do you save and pay cash or do you borrow?  What have you found to work best for you?

Creative Commons License photo credit: jessicafm

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{ 29 comments… read them below or add one }

Ted @broketofree March 15, 2010 at 10:42 am

We just bought a used car and some of it is financed with a 0% interest loan. If I had cash only- I could have knocked another $250-500 off the price (dealer even said so).

We were in a bind with out car dying and not enough money to repaid the car (engine!!) but enough trade value and cash to get a suitable replacement. So the 0% interest loan helped us get a more reliable and better car for our needs.

Paying in cash = better bargaining power.

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Peter March 15, 2010 at 12:18 pm

Our last couple of cars we’ve saved up and paid cash for. It’s amazing how much better a paid for car will drive – or at least I feel better driving it!

Because we were paying cash we were much more selective about what we bought, did a lot more research, and when the right car came around we were able to go out and pay cash for it. Now we’re paying ourselves payments again for our next car!

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joeplemon March 15, 2010 at 12:29 pm

@Ted,
Even with your misfortune…engine! aarrgghh!… you still discovered that cash is the way to go. Your words: paying in cash = better bargaining power are even more true when buying from an individual instead of a dealer. My hunch is that you will get yourself to the point of paying cash for your cars.

@Peter,
You brought out the biggest advantage that one never really understands unless they actually pay cash for a car: being selective. With my last car purchase, I looked and looked and looked before I bought. I found exactly what I wanted on Craig’s list and have loved it ever since. And yes, it does drive better if it is not pulling a bank note behind it.

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lencib March 15, 2010 at 1:24 pm

We’ve been saving up to buy me a car and I may have to wait a few more months to get it, maybe May or June, but it will be worth it! Not having to try to negotiate with a dealership is enough. I always feel pressured at the dealership!

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joeplemon March 15, 2010 at 2:49 pm

lencib,
Awesome! As we have been saying, cash will give you the best buy AND the best peace of mind. Correct me if I am wrong, but it seems to me that I remember reading about your car considerations on your blog. I am glad you decided not to buy new. :)

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Craig Ford March 15, 2010 at 3:25 pm

Joe,
I’ve got a post coming up at Christianpf that is going to share more of my thought on this, but in my case I decided that I’m going to pay cash for cars. Because of my salary that means buying less expensive vehicles. Even at 0% I don’t think I could afford the payments on a new car.
I’ve found that I get the best deals on cars from individuals. Last I checked people don’t offer 0%.

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joeplemon March 15, 2010 at 3:38 pm

Craig,
Dealing with individuals has worked well for me. The main reason is that the dealer has an absolute bottom line: he HAS to get a certain price in order to make a living. Individuals, on the other hand, are normally selling simply to get rid of the car, which gives the buyer more negotiating room. Besides, I just like dealing with individuals.

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Joseph | Kickdebtoff March 15, 2010 at 5:02 pm

Cash is the way to go. Obviously for you to get a near new car and pay up cash will require alot of savings.
We will be replacing my 93 honda sometimes this summer and we are saving up for it – whatever the car we settle for, we will par cash for it. No more car notes for us. They can keep the zero percent.

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joeplemon March 15, 2010 at 5:19 pm

Joseph,
Isn’t saving to pay cash a great feeling? You are not falling for the “gotta have it now” mindset that is so prevalent in our culture.
My wife and I are currently saving up to replace her ’96 Aurora this fall. We won’t be buying any thing close to a new car, but used cars in the $10,000 range have served us well. Like you said: no car notes. They can keep the zero percent.

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Cedric D'Hue March 16, 2010 at 1:07 pm

Joe, great post. Good reasons for paying cash. Haggai 1:1-11 tells us to carefully consider our ways. Using our hard earned cash definitely makes us more selective and more considerate of each purchase.

To be honest, I struggle with some things. This is one of them. I struggle with the depreciation argument and used car preference. I don’t buy a car with the intention of selling it within a year or even ten years. So what if the “value” of the car drops quickly if I don’t intend to trade it in? I know people who trade in their car every three years. Doesn’t make sense to me!
For me the purchase price of a new car makes sense if I know I will use the car until the wheels fall off! Purchasing a $25K new car that should last ten – fifteen years makes sense to me compared to purchasing a $10K used car that may last five – ten years with the risk of increased maintenance.
I guess I look at it a different way. If you have to have transportation that is going to depreciate in value, why not minimize the number of purchases made over your lifetime by purchasing good reliable new cars?

Just my thoughts. Very interested in hearing yours.

Cedric

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joeplemon March 16, 2010 at 4:16 pm

Cedric,
As always, I appreciate your thoughts. We definitely agree that whether you purchase new or used, PAY CASH! I also agree that IF you are going to buy a new car, you should definitely drive it till the wheels fall off, as you suggested.

Still, the depreciation on a new car is huge. If the depreciation is 40% the first two years, that $25,000 new car could be purchased for $15,000 when it is two years old. It makes more sense to me to buy a two year old car and let some one else take that depreciation hit. That is what most millionaires do.

Stated another way, that new car is going to be a two year old used car in two years, so I would rather pay $15,000 to drive the two year old car 13 years than $25,000 to drive a new one 15 years. But maybe that is just me.

Yes, the used car could have more maintenance concerns, but Toyota has been teaching us that new cars can have problems too. I try to find cars that may have a few more years, but low mileage…and I have had very few repair issues with the used cars I have purchased. But, like I said, I have been VERY selective.

In a way, we are splitting hairs. The main thing is to pay cash and, if you buy a new car, drive it a long time. We both agree on those points.

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Larry August 17, 2010 at 6:20 pm

You bet it is, but only if you don’t have to make up for it in the sale price. That’s usually the case in most instances.

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bruno October 15, 2010 at 11:34 pm

where are you getting 8% annual

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joeplemon October 16, 2010 at 7:07 am

Bruno,
My post was talking about a 40 year time frame; long enough to even out the ups and downs of the stock market. Many mutual funds have averaged more than 8% for 40 years, even with the disaster of the past 10 years.

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joeplemon February 9, 2011 at 9:53 am

Michael,
Yes, you might get better rates on new cars than used cars. BUT — you need to re-read this post. Depreciation alone will more than offset that “better rate”. Why not save up and pay cash? Rates, with cash purchases, are always 0%.

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Gao August 22, 2011 at 10:03 am

I think it all depends on the situation. If you are set to buy a brand new car, it used to be you have to choose between a 0% financing deal or a cash back deal. It all depends on the financing you can get, you may save more on the 0% financing than the upfront cash back. or if you find a great financing on your own, then the cashback might be better.

(But recently, I was looking and some places have both a 0% financing deal AND a cash back deal. But on the other hand, it was a Kia, so I doubt you can find one on a more popular model such as a Honda. )

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Bill from Joisey January 10, 2012 at 7:24 am

Depreciation both immediate and over time are the same regardless of the manner in which you purchase your car. It only factors in if you want to consider a good used car vs new and have somebody else take that initial depreciation hit. Even then you need to recognize the reduced trade in value of a car that is a year or two older when you want to replace that car. Discipline in how much you can afford realisticallly is an aside when concerning financing choices. Discipline in budgeting is the BEGINNING of the car buying process. So taking a zero interest rate loan or paying cash is a moot point if the assumption is there is no discipline in the budget process. If you save money to buy a car in cash, that money might be in a savings or money market account for safety but offer very low investment return. Taking out a zero rate loan, vs paying out a wad of cash, can also be viewed as leaving money in a more rewarding investment over 3-5 years. Sure there are savings and price negotiating leverage in paying cash and doing this is preferable to a long term loan at 4-6%. However, basic initial discipline suggests you negotiate to a price you want and no more BEFORE you commit to a method of paying for the car. Finally, I SERIOUSLY doubt that 70% of the wealthy buy used cars unless you are counting 3rd cars and/or collector cars. The higher end car market would not be as large as it is even in tough times if only 30% of the wealthy bought new.

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Joe Plemon January 10, 2012 at 8:46 am

Bill,
Thank you for your well thought out comments. For the reasons you stated, under the conditions you stated them, I agree that there is not much difference between buying new at a zero percent loan or buying new with cash. However, most of my post is a comparison of paying cash for a used car versus borrowing money for a new car at zero percent. I am obviously a huge advocate of paying cash for a used car.

One more thing: I re-checked my source of what percentage of millionaires buy new cars…you are right and I am wrong. Whereas 76.5% of millionaires are not driving new cars, only 37% report that their most recent car purchase was not a new car. My bad, and thanks for calling me on it. I will correct my error in the post.

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Alex January 30, 2012 at 4:05 pm

Joe, this is probably the best article on the downside of using 0% interest that I have ever read.

I will share this with people for years and years.

Sad I missed it the first time around, but I’m glad I caught it today!

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Joe Plemon February 11, 2012 at 3:59 pm

Thanks Alex!

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Sally February 8, 2012 at 9:44 am

I have done all three. Bought new with cash, bought used with cash, bought new with 0% finance.
There are two separate topics. New vs used, and 0% vs cash upfront.
If you are short the cash to buy the new car you want, and you are knowledgeable, lucky and don’t put a value on your time in seeking the perfect used car, then used can save you 15% or so from a depreciation standpoint – whether you keep the car or sell it after three years. I have done this successfully many times in my youth.
Now that I am older and value my time and have the money, I no longer take the risks of a used car.
As far as 0% vs cash, 0% is the better deal. Why? Because the argument that you will get a better deal with cash does not have to be. You do not have to discuss how you are purchasing when negotiating price. Get a cash price quote and then switch it to 0% financed – the dealer should not care. He makes the same regardless. The difference is only in the advertised rebates for cash. In most cases they are less than 10%. Some would say that is why they would pay cash, but.. If you have a mortgage (or any other debt) put the money there instead of upfront on a car, you will make more than that one time 10% loss due to cash rebates. or, if you invest in a long term cd you will have the cash on hand and end up paying less for the car over time. Many times you can also get taxes, registration and everything else added to the 0% finance. Go for the five year 0% if you have the credit – it truly is a 0% loan less any cash rebates. the rebates I was offered( at the time I 0% financed) added up to a one time 5.5% discount. I hope to make at least five times that in compounded interest on my money over the next five years.

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Joe Plemon February 11, 2012 at 4:14 pm

Sally,
Good point that there are two different topics: new vs used and zero percent vs cash upfront.

Obviously, I have a bias toward used, so I would argue to buy used instead of new, regardless of the interest rate of the loan. That was the gist of this post.

But hey…if you are in a position to buy new, good for you. Go for it. Myself? I have no debt, I haven’t had any debt in years and I wouldn’t create debt, even for a zero percent loan. The thought of making monthly payments for five years makes my stomach churn.

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Salma July 15, 2012 at 6:20 pm

We can never save up much for a late model used car. It just doesn’t happen – something always comes up & whatever is saved ends up being used on something else, usually something important like major home repairs, but sometimes we just spend a little more on things bc we subconsciously know we have money set aside. Plus we had to pay for rental cars any time we drove out of town.

Well we finally broke down (literally – our car engine died, on yet another car) and bought a brand new car after 17 years and several cars conking out on us. We were able to get a 0% deal & lots of freebies for maintenance, oil changes, etc (as should be the case with expensive cars) and 2 years later we couldn’t be happier. We’ve saved thousands on the free maintenance provided by dealer, so we consider that in the costs as well. Plus, as Muslims we cannot get a loan with interest so this works perfectly for us. I guess it’s all a matter of each family’s specific situation, but the zero interest loan was a life saver for us!

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Ryan Reger - Business Ideas, Tips, and Strategies August 5, 2012 at 11:17 pm

Great advice, Joe!
My wife and I own both of our cars free and clear, but one of them is getting high in miles. I saw some of the 0% ads recently and thought about this and basically had the same question as your friend. You answer this question perfectly.
We’ll stick to paying cash.

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Joe Plemon August 7, 2012 at 7:24 am

Ryan — Glad to help. Cash rules!

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Cedric August 10, 2012 at 10:59 am

Hey Joe,

What about a post on how to negotiate the best rate on purchasing a vehicle, whether new or used? I’m in the market to buy but just got quoted a rate that is +$7K more than the KBB invoice rate. Ouch.
I’ll use the KBB invoice rate, that I will pay with cash and the fact that I’m helping to clear the lot to negotiate a lower rate but if there are other tips to lower the cost, please let me know.

Someone mentioned cash and 0% financing are the same. I thought the dealer took a little bit of a hit selling the financing. Can anyone verify this?

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Nate September 4, 2012 at 12:48 pm

FWIW – manufacturers who are stuck at the dock will typically kick in additional incentives to dealers to clear their lots to make room for newer model vehicles. This is how I snagged a respectible deal on an otherwise “overpriced” sports car that’s based off of their lower tiered models.

The manufacturer promised 20% kick-back to dealers that could move their inventory before the end of the year. On top of the kick-back, the manufacturer was offering 0% financing. Dealerships who had the inventory, and could turn over vehicles, passed these credits on to buyers, in addition to the financing.

I “saved” 20% off of the manufacturer’s (already inflated) MSRP and was able to purchase a vehicle that has maintained its marketable value. The KBB private party resale of my make and model is only %15 less than what I purchased it for, 4 years ago (5 model years).

So it’s not always about cash vs. 0% and new vs. used. It’s really about doing your research and getting the most for your money. As much as it might sometimes suck having a payment, it’s satisfying to watch the balance near the zero mark.

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Generalisimo September 8, 2012 at 10:06 pm

I agree with the comments about buying used versus new and saving up to buy a car you can afford. In my case I just bought a new Honda (my only new car in 35 years) and took the 0.9% financing. I have the cash but the total cost of financing over 5 years is $620. So instead of giving Honda all the cash now I have to average $104 a year in profit on holding the owed money for 5 years. A simple 2% return leaves me a big winner. Also factor in that as time goes on I’m paying with money worth less and less and the financing is a big win for my bottom line.

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James February 18, 2013 at 6:19 pm

My wife and I recently purchased a brand new car. I’m 38 and this is my first brand new car. Our 13 year old Honda Civic was getting up in miles and we were looking for an AWD vehicle due to the weather where we live. We have been saving for the past 4 years to replace the Civic, so we were prepared to pay cash for whatever vehicle we decided to purchase. I was rather excited about the prospect of paying cash.

Looking for an AWD sedan limited our choices, but we took many test drives on new and used vehicles, researched like crazy people and finally settled on a Subaru Legacy. I would never have considered buying a new car, but the new model had all the options we were looking for, significant improvements even over the previous year and 0% financing. We were able to talk the dealer down considerably below invoice and although we knew we would be taking a hit on the depreciation, we felt better about buying a new, reliable car, that no one had abused, keeping all of our money in the bank and being able to invest and earn a return on it.

The dealer didn’t know if we were going to finance or pay cash until after we agreed on a purchase price. Maybe we could have gotten it for a couple hundred less, but it wasn’t worth haggling over.

So although we now have a monthly payment, we can cover it with our income and have a huge stash of cash in the bank, which reduces our exposure to financial crisis. Plus we will be investing some wisely, so we should see a decent return. The alternative was okay too, we could have paid cash for a used car, not bought the car we wanted, and be left with less money in the bank, but a decent safety net. We chose to enjoy life a little and buy the car we wanted (while being responsible, I mean it is a Subaru, after all :), all the while leaving us pretty well off.

To each their own.

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