How to Buy a Car: Car Purchase Options Explained
Did you know that buying a car is one of the most significant decisions influencing your entire financial situation? For a purchase this large, you should always look at the total cost of car ownership. One more vital factor to consider while purchasing a vehicle is how to buy the car the “right” way. We’ve evaluated five of the most common car purchase options. Consider the buying process holistically: look at all the choices, and the pros and cons.
5 Car Purchase Options Explained
Option 1. Buying a Car with Cash
This is precisely what it sounds like: you pay for the entire vehicle up-front. There are no monthly payments or financing to be concerned about.
Benefits of Paying Cash
- No interest expense. There are no debt service costs to be paid. Debt service is the sum of the principal and interest of a debt over a specific period. Debt service is usually quoted per year.
- Easier to negotiate. Cash can allow you leverage to negotiate a better deal. Car dealers may be willing to accept a lower price if they know the money is guaranteed immediately after signing.
- Not too much car. You’re more likely to buy the “right” car. Because the money is your own, you may feel the pain more when it leaves your account. The vehicle that you choose will meet the sweet spot of what you want and what you can actually afford.
- You own the car outright. If you had leased or financed a vehicle, legally, the title belongs to the entity responsible for financing. This is important, especially if you don’t meet your payments obligations. The title-holder can repossess your car, and you will not get your money back. Instead, you’ve paid cash and hold the title. Owning the vehicle also means that you can customize your ride and drive it as much as you want. You may even leave the country with it. (This is usually restricted on a lease or financing option.)
Drawbacks of Paying Cash
- Decrease cash reserves. You decrease your emergency funds and cash liquidity. There is an immediate loss of cash when you pay for the car. Worse, a car’s value decreases from the time it’s driven off the car lot. Getting back the full cash value is difficult. This does not even count how long it takes to sell the car.
- Opportunity cost. The cash spent on the car cannot be invested somewhere else. You then lose out on an opportunity to generate compound interest on that money.
- Diminished car value is real. If your car is ever in an accident, it will have a diminished value. The car’s value to a prospective buyer will be lower than a similar vehicle without a crash. This is despite it being repaired “as good as new.”
Diminished Value Example: After an accident, your insurance company restores the car to better than its original condition. You want to sell it for $16,000. A buyer insists upon seeing your car’s history report. Due to the accident and repairs of $5000, he decides the car is worth $11,000, and will not pay more. You could keep the car and hope that another buyer pays your price. Or you could accept the diminished value and the buyer’s offer. What’s worse is that you can’t claim this money from your car insurance, and will have to absorb the loss.
Option 2. Financing a Car
Financing a car is one of the most popular car purchase options, especially for people who cannot pay for their vehicle using cash. You’re taking a loan to pay for the car from a dealer or other financial institution.
Benefits of Financing a Car
- You can buy a more expensive car if that is what you really want. When you pay cash up-front for the vehicle, you get the vehicle that you can afford right now. Financing allows us to purchase a better car than we can with the money we presently have available. For example, you may have enough money to buy a used car for $10,000 car right now. With financing, you may be able to purchase a new $30,000 car. The new car is more likely to have a better warranty and fewer problems.
- Build a credit history. Financing helps build your credit history. Your payment habits determine approximately thirty-five (35%) of your credit history. If you make payments to your loan on time, as agreed, you will be rewarded with an improved credit score.
- Opportunity to invest cash. You may get a chance to invest some money. This is a risky situation, but the payoff can be worth it. First, you would need to qualify for a loan with a low APR. (APR or annual percentage rate is the percentage of the loan charged, per year, for borrowing money. It can also refer to the rate of return earned by an investment.) Then, you can reinvest an unused portion of the money in a vehicle with a high APY. (APY or annual percentage yield is an effective rate of return per year after factoring in compound interest.) You will earn money on the difference between the APY and the APR.
- You own the car. This means you can drive it as much as you want or modify it as you wish. Taking the car to another country is generally still not allowed.
- Buying a car that you really can’t afford. It’s good to be able to purchase the vehicle that you think you need. Too many people buy the maximum car they can qualify for, even if the car is too much. In many cases, car owners don’t see or understand the full cost of car ownership.
- Interest expense. You are responsible for debt service costs.
- Can ruin credit history. The penalties for missing payments are harsh. Missing even one payment can have a severe impact on your credit score. If you miss multiple payments, it will devastate your credit history. The lender will come after you to repossess the car.
- Upside down loans. The car loan may be underwater or upside down. Both of these terms mean the same thing: you owe more on the car than the car is worth. Cars depreciate as soon as you leave the dealer and can lose thousands of dollars in value each year. It’s exacerbated if the loan is enormous and depreciation occurs too fast. You may also be underwater if your car suffers damage in an accident.
- Diminished value. If something happens to the car, you are still responsible for it (and the loan payments). It doesn’t matter if the vehicle suffers from diminished value or is completely destroyed. The loan is still valid until it is paid off.
Option 3. Leasing a Car
Leasing a car is also among the most popular car purchase options. When leasing, a dealer will “rent” you a vehicle for a specific time and number of miles. At the end of the lease, you can choose to return the car or buy out the lease and keep the vehicle.
Benefits of a Car Lease
- Low monthly payment. Compared to financing a car, the monthly lease payments are lower. Just like financing a car, you may be able to purchase a better option than buying a car with cash. Your monthly payments are generally smaller than the finance option.
- The process to give up the car is convenient. You won’t have to go through the hassle of trying to sell the vehicle. At the end of the lease, you return it to the dealership.
- Not responsible for diminished value. You may avoid diminished value if you took on the mandatory repairs. This includes preventative and restorative maintenance. The dealer must take ownership of the car at the end of the lease.
- Most expensive way. Leasing is one of the most expensive car purchase options. With financing, you can compare rates between dealerships and financial institutions. Leasing is different; you can only work with the car dealership. There are no options to shop around for a better leasing option like you can with financing.
While the monthly lease payment is less expensive compared to the other options, it has a major financial drawback in the total calculation. With financing or cash purchase, you have equity in the car once the transaction is completed. At the end of the lease, you will have no equity in the car because it returns to the dealership. Introducing the equity into the calculation makes the cost of cash purchases or financing less than leasing.
- Hard to calculate total costs. Understanding the lease payment can be complicated. Take taxes, for example: Do they apply to the total value of the car or the residual value only? Does your trade-in affect the applicable value? Is there a requirement for multiple security deposits (MSD), which causes opposing effects on down payment and APR? These questions make it difficult to determine if your leasing deal is good.
- Lease fees. So many fees! Leasing fees include:
- Acquisition (bank or processing) fee covering the costs associated with working with the leasing company. This fee depends on the dealership and the value of the leased vehicle.
- Disposition fee, calculated at the lease’s end, for the costs associated with returning the car to the dealership. These may include administrative fees and car wash, cleaning and detailing costs for future sale.
- Overage fees. You will negatively affect the resale potential of the vehicle if you drive more miles than permitted on your lease. The dealer may use this fee to recover the diminished value.
- Damage fees, which are assessed for any significant damage to the car while in your possession.
- Security deposit, advanced payment for protecting the leasing company against car damage and non-payment of the lease.
Option 4. Balloon Auto Loan
In a Balloon Auto Loan (or customer choice financing), the interest is paid in the monthly installments. The final payment is a lump sum of the principal (the balloon). Balloon loans are the right choice if you need to have low monthly payments at the beginning of the loan. However, it’s the riskiest of all car purchase options.
- More Debt. Your monthly payments are lower, but your balance is paid slower than traditional financing, which means that you pay more interest.
- Diminished Value Can Occur. The car is your responsibility.
- The Loan Is Underwater. The principal is paid at the end, so the car’s value will always be significantly less than what you owe. In the case of a sale or insurance payment due to an accident, the payout won’t cover the loan.
Option 5. Lease Takeover
This is simply taking over someone else’s car lease. The lessee may have several reasons for wanting to end the lease.
As a new lessee, you may receive the benefits of leasing mentioned in option 3 above, and:
- Possibly a better deal. Someone who wants to get out of the lease may offer benefits to make it more enticing. They may give up the down payment or trade-in, and you may get a lower monthly payment.
- You get a shorter lease term. This can work if you’re in between cars.
- The responsibility for diminished car value does not fall on you.
As mentioned above, leases are expensive overall, and you don’t build any equity. You’re taking on additional risk. Review the lease terms to ensure you know what you’re responsible for, and to avoid extra expenses. You are also on the hook for any physical damage to the car. Before signing, make sure the dealer inspects the vehicle to ensure that it hasn’t been modified. Also, make sure that the mileage allowance is appropriate and has not been exceeded for the lease.
We are not telling you that the only right way is to buy a cheap reliable car and invest the rest of the money. You can make your own decision based on your priorities. What we’re telling you is that you need to understand all car purchase options, so you can make an informed decision that suits you best.