How You Buy a Car Significantly Affects Your Finances

There are not as many financing options to buying a car these days as in years past. Maybe that’s a good thing! People have asked me, “what’s the best way to buy a car these days?” Here’s a few options, from least attractive to the best.

5) Use your 401k to finance the car.This is about the worst idea on the planet. I had someone actually do this before they spoke to me about it, so it was too late for them. But not too late for you. If you think of just some simple math and compound interest you can easily see that this is the most expensive way to buy a car (or anything else for that matter). Let’s say the car is $20,000. Removing $24,000 from your 401k (because 20% will be withheld for taxes), that $20,000 car is actually costing you about $112,000! Check it out for yourself. I used $24,000 at 8% for 20 years. If you’re a young person and could keep the $24,000 in there for 30 or 40 years, the money lost is astounding. (See my article on the magic of compound interest).

You are using your 401k as a financing tool and seriously jeopardizing your long term goals, especially if it becomes a habit. In general, it just doesn’t make economic sense to use long term savings for short term goals, especially when your retirement is at stake.

4) Financing a purchase of a brand new car. New cars are expensive and interest rates are up. The new car depreciates significantly during the first year, so you are paying interest on a constant dollar amount for 4-5 years, but the value of that purchase is constantly declining over that time period. The banks do not adjust the balance based on the value of the car! By the end of the life of the loan your monthly payment isn’t going toward the purchase of a $20,000 car, it’s going toward the purchase of a $8,000 car or whatever it’s worth at that time. In other words your payment remains the same even though the value is declining.

The $20,000 car can cost you up to $30,000 depending on the terms you got, but the car ends up being worth much less than that.

3) Leasing on new car. It’s a toss up whether this is worse than financing a brand new car. Many people justify leasing because they want a new car every couple of years and they can afford to do so. Still, it’s an expensive way to go. There is usually an upfront fee of $999 to $2999 depending on the type of car. There is also some fine print about turn in fees. I’ve seen those as high as $750. You pay them to turn in your vehicle! It’s just crazy. Not to mention the over mileage fees if you are over their 10k or 12k miles per year limit.

All the leasing fees need to be included in the monthly payment calculation over the length of the lease. When you do so, the monthly payment far exceeds the advertised monthly lease rate.

2) Buying a new car for cash. Okay, so you’re wise to all the financing schemes out there and you’ve decided to pay cash for your new car. That is a great goal and makes a lot of financial sense. You can easily save for a new car by driving your older paid off car longer and put the savings into a separate account or Virtual Envelope (see my article on Virtual Envelopes) and before long you will have saved for that new car. You’ll avoid all the financing charges, lease fees, etc and not have a monthly payment – except to yourself so you can save for the next new car.

1) Buy an almost new car for cash. I like this approach the best because the car you are purchasing has already gone through it’s highest depreciation cycle during the first year of ownership. Someone else covered that for you! You get a great price on a car that may only have 8k – 12k miles on it and you’re paying up to 20% less than the original price. You could easily pick up that $20,000 car for about $16,000. Now paying cash is even easier!

Notice the big difference in money outlay as you look at option #5 to #1, there’s about a $96,000 difference. You just don’t notice it because you think you’re only withdrawing $24,000 from your 401k.