Buying a car is one of the biggest purchases most people make. In fact, next to buying a house, purchasing a car might be the biggest financial commitment most of us make in our lifetime. It should come as no surprise that there are numerous ways to finance the purchase of a vehicle. However, which option is best for you? There are many things to consider. A lot of it depends on your personal financial situation. Your credit rating, personal savings, and income level will all play a part. Here is a list of seven options to consider when buying a vehicle, along with the pros and cons of each.
Dealer Financing
How it Works
Dealer financing involves you paying back the cost of the vehicle to the dealership on a set payment schedule and at a set interest rate. You will make periodic payments (usually monthly or weekly) over an extended period. Most of these deals run between 48 and 96 months, depending on the details. You’ll likely get a fixed interest rate for the duration of the agreement.
Pros
This is a pretty straightforward means of paying a vehicle off. The upside is that you will own the vehicle outright once it is paid off. You won’t be limited to driving a set amount of miles, like you would with a lease. Essentially with this kind of payment plan, the vehicle is yours do with as you please. If you can afford the monthly payments and the interest is relatively low, this is a good financing option. Note that 0% interest on this financing option would be ideal, if you can find it.
Cons
For this to be an attractive financing option, the interest rate needs to be low—3% or lower is recommended. If the interest being charged is 5% or more, you should shop around for a lower rate. Also, the length of the loan needs to be negotiated and kept low.
Many dealerships will stretch out the repayment period to keep the monthly payments lower. You might think it’s great that your payments are low. However, if you add up the interest you’ll pay by agreeing to a seven-year finance term instead of a four-year term, you’ll be shocked how much more the car is really costing you. Our best advice is to keep the finance term as low as you can, while still being able to afford the payments. It’s worth hundreds — or even thousands — in long term savings if you can swing a higher payment for 48 months than a lower payment for 60 months.
Bank or Financial Institution
How it Works
Many banks or financial institutions offer specific loans to their customers for the purchase of a car. Similar to dealer financing, these loans are usually for a set period of time and at a set interest rate. You will make monthly or bi-weekly payments on the loan over a few years to pay it off.
Pros
Many banks can offer interest rates that are lower and more attractive than what you can get from a dealership. It’s especially helpful if you happen to have a history of banking with that company. Taking out a loan from a bank and paying it off on time can help boost your credit score. Plus, banks are often more flexible with their repayment periods than car dealerships. If you take out a loan from a bank and use the money to buy the car outright from the dealer, than you no longer have to be bothered with the dealership once you drive the vehicle off their lot.
Cons
Depending on your credit history, a bank may require you to put up some collateral to secure the car loan. That could include something major, like your house. Should you have any problems repaying the loan, the bank could increase the interest rate on the loan at its discretion. Or just seize the car back from you. Also, not all banks will offer low interest rates on auto loans. Always be sure to compare the interest rates available to you — both from bank to bank, but also with the dealership.
Leasing a Car
How it Works
Leases are almost always done through a car dealership. Essentially, you rent the car from the dealership for a set period of time. You make monthly payments to lease the car. These deals are usually for less than a regular finance deal. A common lease only runs for 24 to 36 months. The advantage is that these payments are typically lower than if you were to buy a car outright. When the lease period ends, you return the car to the dealership and simply walk away.
Pros
Leases are great for people who want low monthly payments and like to drive new cars all the time. You can return the car when the lease period ends and quickly get yourself into another car that is brand new. It means you’ll never be stuck driving a 12-year-old car that is on the verge of breaking down. That peace of mind is worth a lot for some drivers. The lower monthly car payments will free up your monthly cash flow too.
Cons
Leases come with a lot of restrictions and penalties. For example, most leases prevent you from driving more than 12,500 miles a year. If you put more miles than that, you’ll end up paying more money in penalties. You also can’t modify a vehicle you lease or damage it in any way. You will be charged for every nick and scratch. The biggest downside to leasing a car is that you have nothing of value when the lease ends. You are not left with a car that you could sell or an asset of any kind. If you continue to lease, the payments never end. At least with a bank or dealer finance deal, the constant payments could stop for a while while you continue to drive the car you now own outright.
Line of Credit
How it Works
A line of credit is a bit like a credit card. You’ll have an available sum of money that you can draw on to buy things. Lines of credit have interest rates attached to them, but those rates are usually much lower than on a credit card. There is no requirements to pay off a line of credit in a set time period. However, you have to make a minimum monthly payment. It usually cover the interest charged, and a small amount of the principle. Home Equity Lines of Credit (HELOCs) are a slightly different type, which are secured against your house. They usually offer larger amounts of money and at lower interest rates.
Pros
As mentioned, there is no requirement to pay off a line of credit in a set time frame. The minimum monthly payments are usually lower than financing through a dealership or getting a bank loan. Also, lines of credit tend to offer the lowest interest rates — especially if they are secured against a larger asset, like real estate. You would have the satisfaction of paying off the loan on whatever schedule you see fit.
Cons
The downside of lines of credit is that the debt on them tends to sit for long periods of time. Since there is no defined term, you might end up skimping on some payments when cash gets tight. That will rack up significant interest charges. Lines of credit are not ideal for big purchases like a car. They require extreme financial discipline in order to not cost you more money in the long run. If you acquire a Home Equity Line of Credit, it means the car purchase is secured against your house. The bank could seize your home and sell it to pay off the line of credit in an extreme situation.
Credit Cards
How it Works
We assume you know what a credit card is. It’s simply a plastic card that you can use to purchase things when you don’t have cash to buy them. There is a set limit on most credit cards — say $10,000 — and an interest rate charged for their use. Some charge an annual fee and offer rewards. There is a minimum payment for credit cards, but it doesn’t always cover the interest.
Pros
As with a line of credit, there is no set time frame for repaying a credit card. Using a credit card to buy a car can be convenient and easy. You’ll own the car right away. You can pay off the purchase on your own schedule. If you get cash back or other rewards, using your card for a large purchase can really boost those points or miles. However, it’s not a great idea unless you’re able to pay off the newly acquired debt in a hurry.
Cons
Credit cards typically charge the highest interest rates. Usually at least 15%, and sometimes as high as 30%. With no set repayment schedule, credit card debt can languish and sit there for long periods of time. Those interest charges will pile on fast. This kind of debt can hurt your overall credit score. With high interest rates, the amount of the debt on a credit card can quickly become compounded. You could end up paying a lot more than the purchase price of the car you bought in the long run. As a rule of thumb, you should never buy a car with a credit card unless you can pay it off immediately. The interest will hit your wallet hard.
Private Lenders
How it Works
Individuals will personally lend you money to buy a vehicle. This usually requires that you sign a contract with them agreeing to repay the loan by a certain date and with a specific interest rate charged on the loan. They could be friends or family members, or just anyone hoping to get a solid return on a chunk of money.
Pros
This can be a reasonable option for people who have bad credit, or don’t qualify for more traditional financing options. Also, the terms of a loan offered through a private lender are often decent, including low interest rates and a flexible repayment schedule. Of course, it will help if you know and trust the person you’re borrowing money from.
Cons
Have you heard the term “loan shark”? When you take out a loan from a private citizen you have none of the protections and guarantees you get from a bank or credit card company. If you don’t make the payments, or if the relationship sours, things could get ugly. Both sides should be leery of making a deal with someone they don’t explicitly trust.
Personal Savings
How it Works
If you have enough money saved in a bank account or retirement plan, such as a 401K or RRSP, it’s another option. You simply withdrawal enough money to pay for your next car purchase outright.
Pros
The biggest plus is that you won’t have to take out a loan. So your debt load will not increase, you will not be charged any interest, and will not have any monthly car payments. In the long run, you can save a lot of money in interest payments. For a rapidly depreciating asset such as a vehicle, many money experts say it’s good to pay for a car in cash rather than taking on debt to cover the cost.
Cons
If you have cash on hand, that’s one thing. There’s no penalties for dropping down a stack on $100s and walking out with the keys. However, if you have to withdraw money from your retirement plan to buy the car, it will cost you. Whatever you withdraw will be added to your income for the year and you’ll be taxed on it. Also, you will lose the interest you were earning on your investments and your retirement fund will take a hit. You should compare the interest you are earning on your retirement investments to the interest you would pay on a car loan before making this decision. It might not really be worth it.
If you so use your retirement fund to buy a car, you should have a plan to repay it within a certain time period. In fact, depending on the saving product you are using, the fund might require your replace those funds within a certain time frame. Do your homework, because you might end up sending the equivalent of a car payment (or more) back to your savings every month — and making less of a return while you do.
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