It is now time for a very brief accounting lesson. When we talk about finance costs, it is important to distinguish between what is actually a cost and what is not.
Let's say you bought a new car for $19,000 in cash. You no longer have the money, but you do have a car of equal value - an asset. If a bank loaned you $19,000 to buy the car, you owe the bank that money, but it still hasn't cost you anything because the car (an asset) and the loan (a liability) are equal in value. However, when you borrow money from any lending institution, not only will the lender ask you to pay back the money they loaned you, but they will also charge you interest. The money that they initially loan you is not a cost, but the interest charge is.
Pay Cash or Take Out A Loan?
For most car buyers, the answer to this question is easy: If they want a new car, they'll have to borrow the money to get it.
But what if a buyer has a choice, to pay cash or to take out a loan? Let's say that Debbie Debtor and Kris Cash each buy a $20,000 car, and each has exactly $20,000 in the bank. Kris pays cash for her car. Debbie puts 15% down, finances the $17,000 difference with a 48-month, 5.75% loan, and puts her $17,000 in a bank earning 3.5% interest. She withdraws $379.62 from the bank each month to pay her car payment, which leaves her with a bank balance of $0 after 48 months.
Kris doesn't earn any interest on her money, but she didn't pay any either, so she has a net cost of $0. Debbie must pay $397.30 each month in car payments, but she can take out only $379.62 each month from her bank account (or else she would deplete her bank account before 48 months). She has to pay an additional $17.68 per month for 48 months, or a total of $848 more than Kris.
Another way to look at it is that Debbie will pay $2,070 in interest over the 48 months but will earn only $1,222 on her money in the bank, a net loss of $848. To make matters worse, Debbie will probably pay income tax on the $1,111 that her money earned in the bank.
The bottom line: As long as the interest rate on the car loan is more than the after-tax interest rate that you could earn on your money, paying cash is less expensive than taking out a loan.
Zero-percent Financing
No-interest loans were once considered a desperate marketing tactic by car manufacturers. But the scheme has proven to be so successful in luring buyers into showrooms that automakers have found it hard to give up this persuasive marketing tool; thus many continue to offer it from time to time.
Unfortunately for manufacturers, consumers have come to expect attractive rates and big incentives to lure them in to dealerships, with showroom traffic slowing when automakers pull back on aggressive financing. These days they are a critical weapon to use in the battle over market share between domestic and import manufacturers but difficult to wean off of once in place.
No-interest loans are clearly a good thing for buyers, removing the finance charges for a loan and enabling consumers to buy more car for the money. Compared to a loan with an interest charge, a no-interest loan can save you thousands of dollars. And, if you're fortunate enough to be Kris Cash in our previous example, you can sign up for a no-interest loan to buy your car and keep your cash to earn interest from an investment.
However, only about half of all car shoppers qualify for zero-interest or extremely low-interest loans. These loans typically require strong credit ratings. That leaves the other half of new-car shoppers who need a loan looking for more traditional financing.
