Few purchases in life will give you a greater sense of mobility or freedom than buying a car. And a reliable set of wheels is an important investment in most parts of the United States.
But like any investment, the stages of buying a car can cause analysis paralysis. And the question of how large the down payment should be confuses many drivers.
By now, you’ve probably heard the old chestnut that 20% is perfect. But at the same time, you’ve also heard about zero down payment deals and people who pay in cash (i.e. 100% down payment).
So what is it? What should be the down payment for the car and why?
Before we discuss down payments, take a minute to use my car availability calculator to work out your budget. Once you’ve decided on a budget, let’s talk about what percentage of that number you need to set aside.
TL;DR 20% new car, 10% used car
While 20% of a car’s retail price is the ideal down payment for both new and used cars, 10% is fine for used cars.
So why is there a difference?
Why are new and used different?
Depreciation.
Research shows that new cars tend to lose about 50% of their value within five years and 20% after just the first year. Some cars—luxury or sports cars, for example—tend to lose that 20% as soon as you drive them out of the parking lot.
So let’s say you buy a brand new 2023 Acura for $40,000 and pay only 10% upfront, or $4,000. The loan amount will be $36,000.
A few months later, the car is only worth $32,000 and the loan balance is still $34,000. You now have a $2,000 loan, which means that if you have to sell your car in an emergency, you still owe money to your lender.
Being underwater sucks, so a 20% drop is a smart move. It keeps you “above the water”.
Why is a good down payment important?
Let’s look at all the reasons why making a hefty down payment can make life a lot easier for you in the future.
Keeps you on budget
Car dealers love to advertise “$0 down, 0% APR” deals because they like to trick customers into buying cars they can’t afford. After all, auto loans are secured loans, which means that if you don’t pay up, your lender can just come and take the car.
Credit: Honda Carland
Reduces monthly automatic payment
The next benefit of a higher down payment is that it reduces your monthly payment.
If you tinker with our handy Auto Loan Calculator, you will see that buying a $20,000 car with a 10% down payment and a 7% interest rate results in a monthly payment of around $460 (assuming the term is 48 months, which is is the longest). recommend).
However, if you can afford it, doubling your down payment to $4,000 will cut your monthly payment by nearly $50. And it really adds up over time.
Reduces the total amount of interest paid (and possibly even your rate)
Lenders make money by charging you interest. If you borrow less money or take out a loan for a shorter term, you pay less in interest.
In the example above, doubling your down payment on a $20,000 car from 10% to 20% also saved you nearly $300 in interest.
And if you make a larger down payment, your lender may also lower your overall interest rate from, say, 7% to 6%. In this case, you will save hundreds more for interest.
Reduces your chances of going underwater
As mentioned above, a higher down payment means you will spend less (or zero) time underwater on the loan.
If you invest 10% on a new $20,000 car, it could be worth $16,000 a month later and you still owe $17,700 for it. But if you put in 20%, you owe less than $16,000 and stay afloat.
Potential savings on auto insurance
Auto lenders require that you have full auto insurance for the life of the loan (i.e. collision, comprehensive and liability insurance combined).
On average, full coverage auto insurance costs about $1,853 per year. But if you were to drop down to the liability level, you would only pay $650 a year (again, on average).
This way, if you make a larger down payment, you can pay off the loan faster and have the option of downgrading your coverage from full to liability only. On average, this can save you about $1,200 a year on auto insurance alone.
Protects your credit score
Your credit score is made up of five different measures:
- payment history
- Credit use
- Length of credit history
- new loan and
- Credit mix
Assuming you make every payment on time, a car loan can actually improve all five aspects. A larger down payment can help even more by keeping credit under control and reducing the risk of missed payments.
Increases your chances of being approved for a loan
Finally, your lender may require a larger down payment to get you started.
Lenders use an indicator called loan to value ratio (LTV) to determine your conditions for a car loan. LTV is simply the amount you want to borrow divided by the value of the car.
For example, if you want to borrow $16,000 to buy a $20,000 car, the LTV will be 80%.
Lenders reward low LTVs with better interest rates. Some even have caps on LTV depending on your credit score (Good = 80%, Excellent = 90%, etc.).
So if you have a credit score below 700, you may need to make a high down payment to lower your LTV and get a loan.
Read more: How to get a free credit report and credit score
Should I just pay cash for the car?
Now, this all begs the question: if a higher down payment is better, why not pay in cash?
When we start talking about upfront cash payments above 20%, the conversation changes from risk to opportunity cost. In short, you are investing money that could otherwise rise in the stock market.
But before I get ahead of myself, let’s talk about the pros and cons of paying with cash.
Advantages of paying for a car in cash
You can save on interest, insurance and stress.
If you pay cash for a car, it’s yours. You don’t have a monthly payment, you don’t need full coverage if you don’t want it, and perhaps best of all, you’ll have one less account to worry about.
It’s also faster. No need to apply for six loans and listen to the dealer chatter about their finance department. Just cut them a check and leave.
All this sounds great, right? But let’s look at the cons of cash.
Cons of paying for a car in cash
Your investment may exceed the interest rate
Let’s say you would like to buy a car for $20,000 and are considering whether to pay money for it or pay cash.
If you take the $20,000 you would use to pay for a car in cash and instead invest it in an index fund with a historical average annual return of 9%, in four years that $20,000 you invested will be worth $28,628.11 dollars. investment calculator.
At the same time, you take out a loan to pay for a car at 5% for 48 months with an initial payment of $4,000. With these loan terms, you will end up paying about $23,000 for the car (loan payments and down payment combined).
$28,628.11 – $23,000 = $5,628.11 profit that you would miss if you paid for a new trip in cash.
Now, obviously there are a few caveats to this:
- Car loan interest rates can vary significantly from year to year, and you won’t always be able to get the super low rate, even with a great credit score.
- The historical average return on any investment is not guaranteed.
But even so far if You can secure an auto loan interest rate of around 5%, you’re probably better off investing that money than paying cash.
Read more: How to invest: basic tips to help you get started investing.
Where to pull cash for a good down payment (savings, investments, etc.)?
Finally, if you don’t have enough money in your checking account for a good down payment, where should you get the money from? Saving? Investments?
In general, it is best to use a check or savings as this money a) does not grow quickly or at all and b) does not incur penalties or taxes on withdrawals.
But if you can wait and start accumulating a paycheck, do it. At the end of 2022, used car prices are finally starting to come down, so the longer you wait, the more you save.
Manheim Used Car Value Index Mid-September 2022
Frequently asked Questions
What is a good down payment on a car?
A good down payment on a car in most cases is 10% for a used car and 20% for a new car.
What is the average down payment on a car?
The national average for a new car down payment was $6,026 in the first quarter of 2022, with an average new car purchase price of $47,077. This is an average down payment of 12.8%.
During the same period, advance payments for used vehicles averaged $3,574, with an average used vehicle purchase price of $33,341. This is an average down payment of 10.7%.
Can you buy a car without money?
Yes, technically you can buy a car without investment. But the terms of your loan will be terrible (if they offer you a loan at all), and you will be underwater on the first day. In other words, don’t do it.
Can I make a down payment with a credit card?
Yes, you can make a down payment on a car with a credit card. The main advantage of this approach is that you can potentially earn a lot of money or reward points, depending on which credit card you use.
However, be aware that the dealer may charge you a 3% transaction fee for using a credit card, which will obviously negate, say, a 1.5% cash reward. And if it exceeds your credit card, it can hurt your credit score.
However, it might make sense if you are trying to meet the minimum spending requirements for a special signup bonus and/or want to take advantage of the 0% APR period on your credit card.
Read more: The best introductory bonuses for registering a credit card
Summary
After all, the old adage “if you can’t afford a down payment, you can’t afford a car” rings true. The silver lining to saving your pennies a little more is that prices have nowhere to go but down.
In the meantime, now that you have a budget and a down payment, let’s find the perfect car and help you lower the price even further. Check out my guide: How to buy a used car (and get a good deal) in 2022.
