Put money down when buying a car?
Q - Should I put money down when buying a car?
A - This is not a simple answer for several reasons, and as with any purchase, the lowest cost is to pay 100% in cash. But since most people don’t have $10,000, $30,000, or even $70,000 sitting around to buy a new or used car, the question many have is: how much should I put down when buying a car?
Purchasing a car creates a transportation expense that includes gas, insurance, and maintenance. What’s different about cars is that they are a large expense tied to an asset you must pay for up front or finance for many years. At the same time, that asset will lose value regardless of how much it’s used. Cars lose value once driven off the lot and continue to decline year after year until the value is close to 0. Once the car’s value drops to about $1,500, it’s worth more for parts than to repair and keep running. When driven off the lot, a new car will immediately lose 10% to 15% of its value. After one year, it loses another 15% to 20%. By year 3, it’s worth half its purchase price. This depreciation creates a liability risk most never think about. For example, if you buy a car with no money down and then can’t afford the payments before the 3rd year, you may owe the bank more than you can sell the car for. Of course, this is why many cars are repossessed - borrowers who can’t make the payments or settle the loan. This situation, called being “underwater,” can persist for years until the loan balance falls below the car's declining value.
To address rapid depreciation, some will purchase GAP (Guaranteed Asset Protection) insurance to cover the difference between the actual cash value and the loan balance if the car is totaled or stolen. A dealership will push the GAP insurance policy without saying that the only reason you need it is to protect you from the rapid depreciation of the item you’re buying. But GAP doesn’t protect you if you change your mind and no longer want the car (and car payment). At a dealership, a GAP policy may add up to $700 to the cost of the car, while adding the protection to an auto insurance policy might cost $50 to $150 annually. Some credit unions may include GAP coverage on car loans at no charge.
A larger down payment doesn’t change depreciation or your loss if the insurance pays you the actual cash value for a totaled car. You may be able to pay off the loan, but not enough to recover your down payment. Beyond enabling a better interest rate on a shorter loan and a more manageable payment, the down payment is essentially paying today, instead of in the future, for a percentage of the car that will depreciate away. Said another way, the total price of the car - purchase price, interest, maintenance, gas, and insurance - is added up and divided by how many months you own the car. This equivalent monthly expense drops the longer you own the car because you’re amortizing the total cost across more months. So, all the down payment did was lower the interest cost and monthly payment of the loan. With 10 years of ownership, the total price won’t differ much unless interest rates are very high or the loan term is very long. [For a $60,000 car, an additional $4,000 in loan interest from a higher rate or longer term is only $33 per month over 10 years, because the effective monthly cost is greater than $700. That’s why spending less on the car to begin with is much more impactful on the expense, perhaps 40% less or only $400 a month.]
Here’s my rationale for a moderate-sized down payment. By moderate, I mean between 10% and 25%. First, it can allow you to take on a shorter loan term (3- or 4-year), reducing interest expense and lowering the risk of being underwater for a few years. Second, it avoids the need to buy GAP insurance to cover depreciation risk with an insurance payout. Third, you’re not taking on as much debt, which helps if you need to borrow more for something else. Finally, if for some reason you had to ditch the car in the first 2 or 3 years, you won’t be underwater and won’t have to come up with the difference to settle the loan.*
For example, you buy a $40,000 car and put $8,000 down (20%). You pay off the loan, drive the car for 12 years, and it’s worth $2,000. The total cost of ownership is the $8,000 down payment, all the loan payments, gas, insurance, registration, taxes, and maintenance over 12 years, less the $2,000 you get back at the end. The down payment was just a way to pay up front rather than over time. As noted, it may not matter much in the equivalent monthly transportation expense over the 12 years.
I recommend 3- or 4-year car loans because they give you more certainty in your household finances than 6- or 7-year loans. You’re less likely to have 2 car loans at the same time or a large home maintenance bill at the same time. Finally, another benefit of the larger down payment is the potential to refinance. If a year or two into a 4-year loan you’re able to refinance to a 2- or 3-year loan at a much lower interest rate, since you won’t be underwater, it will probably be a no-fee or low-cost transaction. If you had to refinance into another 4-year loan to lower the payment (extending the original term to 5 or 6 years), you still won’t be underwater, so refinancing is possible.
Now, you can work out the numbers under different options down to the penny and find combinations with a zero down payment that keep savings in a money market fund that show you coming out ahead. But a longer loan term or a very high payment can cause other problems. Would you rather pay off a car in 3 years and have 7 years with no payments, or 7 years of payments and then 3 years with no payments? When it’s all said and done, I believe it’s best to have no more than a 4-year loan, and if that means a higher down payment (and a lower-priced car), then find the money to put down more and afford the 3- or 4-year loan payment.
* You might be thinking: I’ll accept the risk of being underwater on the loan for 2 or 3 years because I plan to keep the car at least until it’s paid off. That’s a risk worth taking if you have the financial security to cover the worst-case scenarios, such as insurance not covering your loan balance or a cascade of expensive repairs after the warranty runs out. Both GAP insurance and extended warranties are expensive for the actual amount of liability risk you’ll face.
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