How To Buy A Car?
When Alison got her driver’s license, her grandparents gave her a used vehicle that they were no longer using. John bought a car in cash with money he’d been saving up for a few years from mowing lawns and working at a grocery store. Pete had $1000 down payment saved up and took out a loan at a local car dealership. Of the three, Pete had the newest vehicle, with the most options. The financing decisions you make in conjunction with getting a car can make a big impact on the total cost of the car in the long run. This section will examine some of the options.
Many college students need a vehicle to get to and from school or work. Unless you live in a large metropolitan area with a robust public transportation system, you will need to have a vehicle for much of your life. The patterns that you establish now could save or cost you thousands of dollars over the course of a lifetime.
Here are some general “rules of thumb” related to automobiles from financial planning experts:
Leasing vs. Buying
Leasing can cost you more money than buying if you are unable to follow the leasing restrictions. They may include a limitation on number of miles driven each year and a penalty if you need to return the car before the end of the lease period.
Should You Buy a New Car or a Used Car?
Don’t buy a new car, unless you can purchase it with cash.
Buying a used vehicle is a better investment than buying a new vehicle. New vehicles lose significant value in the first year.
The Difference Between Financing a Car and Paying Cash
You will always pay more for a vehicle if you finance it than if you use cash.
While some people view automobiles as a way to get from point A to point B, the majority of consumers see automobiles as a reflection of themselves. Put simply, cars are status symbols in our society.
Using a car to elevate your status, especially when you have limited financial means, could cost you the very money you actually need to improve your wealth and build status.
Did you know that establishing bad automobile financing habits early in life, could cost you over a million dollars in long-term savings? Take a look at this example:
Mike has chosen to purchase a new car for $22,000 with a $2000 down payment. John purchases a used vehicle, with similar features, and pays $10,600 cash for it.
|Car Purchase Price||$22,000||$10,600|
|Tax and Title||$2,000||$1,000|
|Balance owed after 3 years||$12,400||0|
|Trade-in value in 3 years||$10,600||$6,000|
|Out of Pocket Cost to Trade||$1,800||0|
|Cost to Drive for 3 years||$19,100||$5,600|
|Amount John saves compared to Mike||$13,500|
|Savings in 35 years, assuming pattern continues and savings are invested in 401 (k) plan at with average 8.5% return, compounded annually||$1,067,000|
Financing a New Car
Mike enjoys cars, so he buys a new one every three years. He currently has his eye on a sporty model that costs $22,000. His monthly payment is $425. After three years, Mike trades in his car and repeats the cycle. The trade-in value of his car is $10,600, but the balance on his loan is $12,400. Mike is upside-down in the loan and must find $1800 to pay it off before buying his next vehicle.
Over three years, Mike made 36 loan payments of $425 a month, totaling $15,300. If we add Mike’s $2000 down payment and the $1800 he owes to pay off his loan, it will cost Mike $19,100 to drive his car for three years.
Buying a Used Car With Cash
Meanwhile, John only buys three-year-old cars and pays cash. Since car models change every four years, John’s three-year-old car looks almost identical to Mike’s. However, John only paid $10,600 for his three-year-old car, plus $1000 for the taxes and title. After three years, John sells the car for $6000. John’s cost to drive the car for three years is $5600. The difference between John and Mike’s car costs over three years is $13,500 or $375 a month.
Just to make things interesting, let’s assume that John invests this $375 and it grows at a rate of 8.5%, compounded annually.
Next, let’s assume John and Mike repeats this cycle for thirty-five years.
By the time John and Mike are in their 60s, Mike will have enjoyed driving a new car every three years, while his friend John will have enjoyed driving a “new” (meaning different) three-year-old used car every three years.
By investing the savings with an average return rate of 8.5%, John will have accumulated more than $1,067,000 over a 35 year time period.
You can see that the perpetual financing of new cars can potentially cost someone over $1,000,000 in investment income. Instead of paying more to appear prosperous, consider driving a less expensive vehicle in order to actually become prosperous. Remember, looks are deceiving.
Tips for Financing a Car Purchase
Now that you know how much financing can cost you, let’s talk about how to finance in the smartest possible way.
Smart car financing consists of:
1. Making a budget before you purchase
2. Maintaining a good credit score
3. Comparison shopping for the best car price AND the best loan terms
4. Not agreeing to a loan term of longer than 3 years maximum. If you get a loan of 5 or even 7 years, the total cost of the car in the long-run will be quite substantial with the added interest costs. You may reduce the monthly payments by stretching out the loan but you have added to the total cost of the car.
Your Transportation Budget
The purchase price of the vehicle is only the beginning. If you rely on a car for school and/or work, you will need to consider many additional expenses, including:
- Maintenance fund: oil changes, unforeseen breakdowns
- Insurance: comparison shop for a good quote before buying
- Gas: is it worth it to you to pay for a more fuel efficient vehicle
Consider buying a less expensive car so that you have more money in your budget to handle maintenance, insurance and gas.
It is very important that determine what you can afford. Do not let a car salesperson push you beyond the limit that you have predetermined, based on your budget. Remember, don’t allow the length of the loan to be increased just so that you can afford the monthly payments. If you can’t afford the monthly payments on a 2-3 year loan, you probably need to look at a cheaper car.
Your Credit History and Score When Buying a Car
Your credit score will determine the interest rate you pay on an auto loan. If you want to think about it differently, you can consider that the price you pay for a financed vehicle is largely determined by the interest rate on the loan.
Want to lower the price of your next financed vehicle? You’ll need to have an excellent credit score to qualify for the lowest possible interest rate.
Here are some strategies for establishing a strong credit history and score:
If you do not already have a credit card, open up a secured credit card at a bank or credit union.
You will be issued credit equal to the deposit you make. Do not get into the habit of using this secured credit card for purchases you cannot otherwise afford. You should use it exclusively to establish a credit history. Always pay your monthly bill in full and on time.
When determining your credit score, the credit reporting industry uses the following criteria to rate you:
Always use a small percentage of your available credit. Ten percent or less is ideal. For example, if you have a credit card with a $1000 limit, you should try not to use more than $100. Using a higher percent of your available credit will negatively impact your credit score by increasing your debt-to-income ratio.
Imagine that you are being graded on your reliability. If you pay late or miss payments altogether, you will be considered ‘unreliable’ and your credit score will drop. Your ability to consistently pay on time is the largest factor determining your credit score.
Length of Credit History:
The longer track record you have, the better. Imagine that you were going to loan money to a stranger. Would you feel better about loaning money to person A who can prove a 1-year history of making on-time bill payments or person B who can prove a 10-year history of on-time bill payments? You want your credit history to show good habits over a long term. Unfortunately this is one area where being “young” penalizes you. If you are new to the credit market, you will not be rated as high as someone with a longer history of credit usage.
Take a look at this chart to understand the credit score factor breakdown for a FICO score:
We’d like to dispel the “Good Credit Myth.” Many people believe that they need to carry a balance on their credit card in order to establish good credit. You can maintain near perfect credit paying your bill in full every month.
Comparison Car Shopping
Before purchasing a vehicle, you should attempt to find the best possible price for the vehicle and the best possible loan terms.
Check your newspaper, online auto sites and local dealerships.
After making a budget and understanding what you can really afford, shop around for the best possible loan terms.
Remember that all loans are not equal. By making a hasty, un-researched choice, you could pay thousands of extra dollars for your vehicle over the course of the loan.
The good news is that you have choices when it comes to financing. Check multiple sources including a local bank, credit union and the dealership.
Beware of Co-signing on an Automobile Loan
Never co-sign on an auto loan for a friend or family member unless you are willing and able to pick up 100% of the payments on your own.