Why You Should Consider a Car Loan, Even If You Can Pay Cash

Unless you’re in the market for a vehicle that’s seen more miles than your typical aircraft, chances are good you’re going to be shelling out at least a few thousand dollars on your next automobile purchase. And if you want something made this decade, you could easily see a five-digit price tag in the window.

Given the sky-high prices of a decent car these days, financing a car purchase is simply a matter of course for most consumers. But, even if you can pull together the cash to buy your next vehicle outright, you may have a good reason — or four — to take out an auto loan, instead.

  1. Establish & Build Your Credit History

Depending on your age and financial history, you may be purchasing a vehicle before you’ve even established your consumer credit history. In this case, an auto loan may be a good way to establish your profile and start building credit.

For one thing, most auto loans are secured loans, which means the credit line for the loan is secured by a form of collateral — the vehicle you purchase, in this case. Essentially, if you default on an auto loan, the lender can typically repossess your vehicle and sell it to try and recoup lost funds.

Since lenders have some way to get their money back (or most of it, anyway), secured loans are typically considered to be less risky than unsecured loans. This can make it easier to qualify for an auto loan than other types of loans, especially if you have a limited credit history. Additionally, auto loans tend to have lower interest rates than other types of loans. This makes them less expensive overall, as you won’t be paying as much in interest fees.

Both your approval chances and your interest rate will depend on your credit, income, and the terms of your loan. Making a down payment or using a cosigner can help increase your chances of being approved, as well as likely improving the interest rate you’re offered.

It takes at least six months’ worth of credit history to be eligible for a FICO credit score, which means you should ensure your auto loan terms extend at least six months. Most creditors like to see at least one year of credit history for approval, however, so you may wish to consider a slightly longer loan.

  1. Diversify Your Credit Mix

Another reason to consider taking on an auto loan, even if you can pay cash, is to diversify your credit mix. About like it sounds, your credit mix is the factor of your credit score that considers the variety of credit types in your credit profile.

Creditors like to see that you can responsibly handle different types of debts, including a mix of installment loans and revolving credit lines (e.g. credit cards). As a reflection of that, most credit scoring models incorporate your credit mix into the calculations. In the FICO Score model, your credit mix is worth up to 10% of your credit score.

Of course, you don’t need to take on a four-year auto loan just to diversify your credit profile. Positive credit accounts usually remain on your credit profile for up to 10 years after the account is closed in good standing, so even a year-long auto loan can help your credit for up to a decade.

  1. Take Advantage of Dealer Incentives

Outside of your credit profile, you can also find financial reasons to consider a loan — especially if you can pay it off quickly. That’s because some dealers may provide special incentives, such as a discount off the vehicle’s purchase price, to encourage buyers to finance their purchase through the dealer’s in-house or third-party partner lender.

The catch? Chances are pretty good you won’t get as low of an interest rate through the dealer’s lender as you would going through your local bank or credit union, particularly if you have good to excellent credit. Plus, lender fees, like the origination fee, may be higher than you’d pay elsewhere.

car shopping affect on credit

In many cases, if you already have the cash to purchase your vehicle, then you can enjoy dealer incentives without the extra interest fees simply by taking the loan, getting your discount, then paying off the loan in full with the cash you already had set aside for the purchase.

The one thing to watch out for here is to ensure your loan contract doesn’t include a prepayment penalty, which is a fee charged by lenders for paying off your loan before the end of its term. Some lenders charge prepayment penalties to avoid, well, prepayment, as paying off your loan early reduces the amount of interest you pay overall, cutting into the lender’s profit.

  1. Limit Your Opportunity Cost

The last big reason to consider an auto loan when you could pay cash is the opportunity cost of that cash. The opportunity cost of your money is the consideration of what else you could do — and, specifically, the profit you could earn — if your cash were not tied up in your vehicle.

In other words, if you use your cash to purchase a vehicle outright, that cash is no longer available for other investments, such as stocks or bonds. Depending on the rate of return you could see by investing that money in something other than a vehicle, you could actually be losing money by paying cash instead of getting an auto loan. This can be especially true if you have good to excellent credit and can get a particularly low interest rate on your auto loan.

Here’s an example: Imagine you have $10,000 to purchase a vehicle. If you were to buy the vehicle outright, you’d effectively save the 3% to 4% (for good credit) you would have spent on interest fees for a loan. On the other hand, if you were to take out the loan, then invest that $10,000 so you earn, say, a reasonable 5% return, you would wind up earning more money on your investment than you would spend on interest fees for your loan.

Of course, the math for this strategy will vary widely based on your individual financial situation. If your credit isn’t good enough for a low rate, for instance, you may not come out very far ahead (though building your credit may be worth the interest fees in some cases).

Additionally, not everyone is comfortable carrying debt of any kind, let alone what may be a five-digit debt, so this may not be the best strategy for everyone’s peace of mind. You should also consider whether you can realistically keep up with the monthly loan payments; if you think you may forget a due date or have other issues, you may be better off simply purchasing your vehicle with cash.

 

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