[Australia] Should I Buy a Car Outright with Cash, or Take Out a Loan?
I’ve written this with an “Australia” tag, but the concepts can equally be applied to anyone anywhere because the logic is the same. However, I’ll be making references to Australia because it is the financial market I understand best.
In the interest (no pun intended) of keeping this article shorter, I won’t be defining the terms (there are plenty of websites out there that already do this). If there are some terms you encounter in this article you do not understand, just google them 🙂
In this article, I will be writing about:
- When it is a good idea to get a car loan
- When it is not a good idea to get a car loan
- The thinking behind interest rates and why they are set at the levels they are set at
- Comparing your potential car loan (and home loan) scenario to alternatives
I will not be going into details about:
- Variable vs Fixed loans (do variable loans even exist for car loans?!)
- Secured vs Unsecured loans
- Cars likely to appreciate vs cars not likely to appreciate
- Most cars are not considered to be appreciating assets. In the case of those that are, you’ll likely see increased costs elsewhere, such as maintenance, insurance and a higher upfront cost
- Early repayment and/or exit options and their associated fees
- However, I will point out that if you have these options for free, there is no reason not have these options as it obviously gives you a great level of flexibility
- Potential impacts on credit score
- Needless to say, taking out a loan and being prompt with your repayments is likely to have a positive impact on your credit score – but you can build your credit score through other means (e.g. Credit Cards)
- Your eligbility to get a loan – typically dependent on your terms of employment and/or salary
A question was recently put to me about whether to take out a loan for a car purchase, or pay cash outright.
The short answer is: it’s probably better to pay in cash if you have the available funds for it.
I say this with the assumption that you have nothing “better” to do with your money.
If you don’t have the full funds for it, it’s probably still a good idea to put as much of your liquid funds as possible to the purchase so that you take out a smaller loan, and thus lower the principal on which the interest is getting charged
But of course, there is a (much) longer answer.
It’s important to consider the common loans in the market:
- Home Loans (2-5%)
- Car Loans (5-12%)
- Personal Loans (7-15%)
- Credit Card Interest (17-26%)
Loan interest rates are approximated based on my knowledge of the Australian financial market.
Basically, it boils down to your answer to this question: If you do have the cash, what would you be doing with the cash if you did not put it towards the purchase of your car?
For example, would you be:
- Investing (in stocks, property, cryptocurrency, forex)
- Purchasing necessities?
- Putting it in an interest-earning account?
- Putting it in an offset account? [Australia]
When you should consider taking out a loan
If your answer is investing, then if you believe your return from your investments will be greater than the interest rate you will be charged for your car loan, financially, it is a better idea to take the car loan, because you’d be using the money to hopefully get money from your investment.
In other words, your revenue (return on investment) would be greater than your cost (interest rate on the loan).
This can manifest itself in other forms, such as investing in a business. However, this becomes much harder to quantify. The thinking remains the same – if you believe the money you put towards investing in a business (“revenue”) would be greater than the interest charged as part of your car loan (the “cost”), then you should take the car loan and put the money towards the business.
When you shouldn’t consider taking out a loan
Moving on to the interest earning account. What does that get you? Probably no more than 2% p.a.
Oh – and if you’re in Australia earning a salary, don’t forget that gets added to your taxable income at the end of the financial year.
Offset account? Your home loan rate is probably somewhere around 3-4%, so putting this money would be “saving” you the equivalent of 3-4% in annualised interest.
That means if you have the cash in either your interest-earning account or your offset account, compared to the interest rate you’d be charged on your car loan, it would absolutely be financially wiser to not get a car loan and just take out the cash from your interest-earning account and/or offset account.
If you’d be purchasing necessities, and you’d have to otherwise obtain a loan to purchase these necessities, what would the interest rate be on your loan to buy your necessities?
The Thinking Behind Interest Rates
Notice the variation in the interest rates?
Think of the car loan – the bank is able to hold your car (the asset) as a “security” in case you default (can no longer repay the loan), and this somewhat offsets the risk of the bank lending to you. Compare that to a situation where you need funds to buy milk, bread, or pay for a dental appointment. What is the asset that the bank can realistically hold as collateral and obtain some value in case you can’t pay back the money?
These examples are relevant in the case of either a personal loan or your Credit Card interest. Your Credit Card is effectively an “unsecured” loan. That is, you can buy almost anything on it, and the financial institution who has given you this line of credit has no access to any of your assets in case you cannot repay them, so in “return”, they charge you higher interest rates to cover their risk.
The same logic applies to a home loan, and it is precisely why interest rates on home loans are typically much lower than that of many other assets, and it all comes down to risk. That is, you’re taking out a loan for what is typically considered to be a “safe” asset, and one that is in fact, likely to appreciate in value. There’s also the additional factor of being able to rent out your property, which can also be used to pay off your loan. Can you rent out your car? Ok, I guess you technically can, but good luck getting a bank to recognise this as income on a loan application!
What about using cash to pay for a home?
The exact same line of thinking can apply to taking out a home loan. That is, if you have the cash, you could consider paying for it outright. Of course, there are significant differences between taking out a car loan and a home loan, such as tenure, interest rates and the exorbitant difference in sums between a typical car and that of a typical home.
You have to consider – at your current stage of life, maybe you think, “I don’t need this $500,000. I’m just letting it sit in an interest-earning account right now anyway”. Consider that whilst you might not be investing now (even though maybe you should have, especially if you’re sitting on a war chest of $500,000!), some time through what would have been your 30 year home loan, you might chance upon an investment opportunity that interests you. One which requires you to have access to some liquid funds. But remember that time you decided to pay for your home in cash years ago? That money’s long gone – and that is the opportunity cost you should consider in any of your financial decisions.
Should you buy the latest iPhone for $2000, or should you invest the $2000 in the stock market and hopefully gain a 6% p.a. return, and see a $120 in profit in a year?
With that being said, it’s definitely a different ball game when you compare the dynamics of a home loan versus a car loan, but conceptually, it is similar.
In summary, if, instead of getting a car loan, you would be investing your money in an investment vehicle (e.g. stocks) that you believe would earn you more than your cost of borrowing (interest), then you should still take the loan because you’ll financially be ahead.
It’s all about weighing up your options, which is an extremely important skill when it comes to make sensible financial decisions!