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Is it Better to Pay Cash or Finance a Used Car?

Weíve all been in the position where weíve considered whether it was more advantageous to finance a car or to pull the money out of the bank and pay for it in cash. While most everyone is intrigued by the idea of paying for their new purchase with cash, it isnít necessarily the right decision for everyone. Here are a few items to consider.
What Are the Advantages of Paying in Cash?
If you have the funds in the bank, and paying cash for your car wonít deplete your emergency fund, reduce your ability to make your monthly bills, or get in the way of saving for the down payment on a home, paying for your car in cash can be a good idea. One advantage is that paying cash can keep you from buying more car than you can afford. If you have $15,000 in your car fund, you're likely to look only at cars that cost that much. If you're financing, it's easy to be tempted just to add a few extra dollars to the monthly payment or stretch the loan length out to buy more car.

How Much Will Financing Cost Me?
Hereís a simple example of purchasing a used car for $15,000 and financing it for 48 months at a 4.0% interest rate. The total interest youíll pay is $901 or $18.77 per month. Thatís probably less than you would have guessed. In fact, outside of a home mortgage, particularly with the home interest tax deduction, an auto loan should be the second least expensive loan among your finances.

Whatís the Cost of Paying in Cash?
That depends upon your financial situation. There are several calculators available online that help you determine your monthly expenses and how much you should hold in reserves should you lose your job or thereís some other gap in your income. Financial experts suggest that you donít access those funds for car payments as you may need them for more critical needs.

What are the Advantages of Financing?
It turns out to be the opposite of paying in cash. With monthly payments you may be able to afford to move up a grade level on the car or truck youíre considering for just a few additional dollars a month, rather than being trapped by your budget into a vehicle youíre not really that crazy about. Remember that beyond the monthly payment, you also have to live with your vehicle for at least a few years.

What Else Can You Pay Down?
If youíre sitting on credit card balances, chances are your interest rates are higher than what your car loan would be. It would make the most financial sense to pay down or pay off higher interest loans than it is to take the cash and purchase a car instead of paying the lower interest rate. Always look to put whatever extra money you have available to pay down your highest interest debts.

Itís Not All or Nothing
If youíd like to avoid paying as much interest as possible, yet you donít have access to the full amount of the purchase price, consider making a larger down payment. Of course, only do so if your other debts are paid down or have a lower interest rate. Taking our example from above, if you were to make a down payment of $4000 instead of $2000, the total amount of interest drops to $762 for 48 months or $15.87 per month.

Make Additional Cash Payments
As car loans are not front-loaded like mortgages (where with a mortgage you pay the interest first on a sliding scale with your payments weighted more heavily toward equity only towards the end of the term). Instead, car loans accumulate interest on a monthly basis. If you pay off your loan early, thatís less interest that youíll have to pay. So if youíre expecting a big bonus, you can apply that to your loan to pay it off more quickly. Even if youíre not expecting a windfall of cash, paying a few extra dollars each month can reduce the amount of interest that you pay in total.

Your Car as a Cash Source
Once youíve paid down the balance on your car, you can refinance it and take whatever equity has built up and use it to pay off higher interest rate loans and credit cards. This is true if you pay it off entirely in cash or if itís financed. The equity will just take longer to become available if youíre financing.

In Summary
So while the idea of paying for your car, truck, or SUV with one big bag of cash is a great fantasy, itís unlikely that many of us will have the opportunity to do so. Instead set a budget based on your income and expenses, stick to it as close as possible, make sure your credit report is up to date, and shop around to get the best financing deals.
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