The Simple Dollar - “How to Switch to Paying Cash for Your Car”

How to Switch to Paying Cash for Your Car

Posted: 24 Sep 2014 07:00 AM PDT

In 2003, I purchased a 1997 Ford F-150 pickup. Given the financial disaster that my life was at the tiem, I “paid” for it entirely with a loan, which saddled me with car payments for the next three-plus years.

In 2010, the Ford F-150 needed to be replaced, so we bought a 2004 Honda Pilot. This time around, we paid cash for the whole thing. No loans were involved – we just paid cash.

This was a pretty major transformation. I went from an approximately $10,000 car loan to paying $10,000 in cash for a car. The difference, of course, was a lack of car payments, but it also saved us thousands of dollars. Literally.

Let’s walk through this change and how you can make it happen in your life.

How Much Money Can You Save?

Let’s assume that you’re buying a late model used car for $10,000. Current used car interest rates clock in at 4.75% or so. If you get a 48 month used car loan for that $10,000, you’re going to be facing a monthly payment of $229.16. Over the course of that loan, then, you’ll be paying $10,999.68 over the course of that loan. In other words, you’ll just be handing the bank $999.68.

On the other hand, let’s say you do this beforehand. You put $229.16 into the bank each month – the exact same amount you’d be paying on that loan. That savings account earns a 1% return. After four years, that account will have $11,218 in it. Pay $10,000 in cash for the car and you still have $1,218 in your hand.

The difference between saving up for a car and using a car loan is $2,217 for a $10,000 car – and this is at a point where the interest rates are about as strongly in your favor as they have ever been. If interest rates on loans ever go up from here, the number is going to get bigger and bigger.

In other words, the practice of saving up for a car and paying cash is going to save you a significant percentage of the value of the car – 20%, easily, and usually far more – compared to taking out a loan for that car.

How Can I Make This Change?

The process is actually pretty easy. It just involves making a few smart moves.

First of all, you should subscribe to the “drive it into the ground” model of car ownership. It is much, much more difficult to adopt a cash-only car buying routine if you’re buying new or late model used cars and quickly upgrading in a few years.

By “drive it into the ground,” I mean that you should keep up maintenance on the car and continue to drive it until it begins to no longer be consistently reliable or repair costs approach the value of the car. Depending on the model, this milestone could be reached anywhere between 125,000 and 300,000 miles (or even more).

Of course, you’ll want to be on the higher end of that range, and the way to do that is to stick with car brands that have a strong reliability record. The easiest way to find that information is to head to the library before your next car purchase and look at recent editions of the annual Consumer Reports car buying guide. These provide a list of different car makes in order of their reliability as reported to Consumer Reports through reader surveys.

So, the game plan is to to drive your current car until you can’t drive it any more. There are a few situations you might find yourself in as you adopt that plan.

First, your current car might be on a lease. Your game plan should be to buy the car at the end of the lease provided that the price is reasonable. This may involve a loan (for now), but we’ll get there in a minute. Note how much your monthly lease payment is.

Maybe your current car is still on a loan. If that’s the case, simply note how much your monthly car payment is.

What if your current car is loan-free? Look back and see how much your monthly car payment was.

In each of these cases, you should have a monthly number in mind. As soon as you are free of payments, you should start paying that amount to a savings account each month.

So, let’s say you have a $250 car payment each month. Maybe it’s a lease. Maybe it’s a car loan. Regardless of the reason, as soon as you’re free of that payment and wholly own the car, switch to making those payments to a savings account.

I suggest making those payments automatic, much like your car payment likely already is. Just ask your bank to make a monthly transfer to a savings account for you. Most banks can automate transfers between checking and savings accounts upon request.

When you reach a point where you need to replace your car, take a look at this account balance. That’s what you’re going to be using to buy a replacement car.

You might end up buying a very used car at this point because you’ve only saved for a few years. That’s okay. Just drive this used car for a few years and your account will have built up a healthy balance, plus you’ll enjoy very low insurance rates during that period.

If you truly cannot afford a reliable car due to the low balance of that account (this might happen if you’re buying a car only a few months after starting), take out a car loan for the new car then switch back to paying it off. As soon as this loan is paid off, switch to saving the amount of your old car payment each month.

After the first car purchase completely from the account, you can usually trim back your monthly payment by about 50% or so as long as you stick to the “drive it in the ground” philosophy. So, in the example above, you might trim back your monthly contribution to $110 or so. Over the course of eight years, that amount will add up to more than $10,000, more than enough to buy a reliable late model used car.

What if you only want new cars? If you’re only going to buy new cars or if you’re only going to drive cars until the 100,000 mile mark or so, you’re going to have a very hard time switching to paying cash up front. The only way you can get there is to save each month beyond your car payment until you have enough in savings to make a purchase and, at that point, you’ll need to seriously bump up your account contribution to the level of your old car payments (or more).

This is a very poor financial strategy, however. New cars – especially anything beyond economy models – are incredibly cost-efficient and devalue rapidly almost as soon as they leave the lot. Similarly, selling off a car before you’re close to the end of the car’s life essentially sacrifices your car’s most financially efficient years. I really recommend the strategy of buying late model used and driving it until it’s no longer reliable as those are the most financially efficient years of car ownership.

Final Thoughts

The entire goal here is to transition to a situation where you can just pay for a replacement car whenever you need it out of your savings account and the account continually builds itself back up because you contribute $100 a month (or so) to the account like clockwork.

This is exactly the situation we find ourselves in. We put aside about $250 a month ($125 per car) for car replacements and we plan to do that as long as we’re a two car household. Whenever we reach a point where we need to replace a car, we’ll just tap that account and use the money to buy a late model used car (or possibly a new economy car, depending on discounts and other factors).

This level of funding enables us to constantly maintain two high quality reliable automobiles. One is an efficient economy car that Sarah uses primarily for commuting and the other is a larger vehicle used for our family needs.

Our goal is to never make a car payment ever again and, with this account and this savings plan, that kind of future looks very possible.

Can you do this? Absolutely. The real key is to just transition your car payments to your savings account once your current car is paid off. If you do that – and you stick with your car for a few more years – your savings account will have more than enough money to pay for it. That’s a pretty good feeling – and it’s one that will help your financial bottom line.

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