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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