Is Paying Cash for a Car Really the Best Deal? Experts Calculate It Is

Although car payments have become a permanent part of many Americans’ financial lives, there remain a fortunate few who because of high incomes or disciplined saving are able to pay cash when they buy an automobile.

But even if you are among that lucky minority, you may still wonder whether paying cash is really the best financial strategy. A growing number of car dealers are now producing calculations that purport to show that it is not.

Commonly, their pitch goes this way: As you propose to pay cash, they offer to “show you how you can save a little money,” as one put it recently. The dealer then produces numbers showing that the total amount of interest that you will pay over the life of your car loan is less than the interest you would earn on the same amount during the same period if you kept it in, say, a money market fund.

These numbers appear to work even if the interest rate on your savings is less than the rate you would pay for your car loan. The explanation they give is that interest is paid on a declining balance in a car loan, while earnings in a savings account compound, so over the full term, your earnings will exceed your costs.

For example, if you borrowed $15,000 for four years at 11%, you would pay $3,609 in interest over the life of the loan. At the same time, if you kept $15,000 in an account earning 8%, it would earn $5,635 interest if it compounded monthly during the same period.

So it makes sense to borrow for your new car and keep your cash in your money market fund, right?

Wrong.

While the numbers the car dealers offer are arithmetically correct, they ignore another important factor: If you take out a loan, where do the payments come from?

If you take the payments out of your savings account, it doesn’t earn as much as the dealers’ figures show. In fact, according to calculations done by Alexandra Armstrong Advisors Inc., a financial-planning firm here, the $15,000 car loan would eat up your $15,000 money market account in a little over three years and you would have to chip in an additional $1,202.

If you take the payments from your other income, you are diverting money that could otherwise go into savings or investment and create new earnings. If you put the monthly loan payments of $387.68 into a money market account at 8%, in four years you’d have a total of $21,846, according to the Alexandra Armstrong Advisors calculations.

Neither of these effects--the draw-down of your savings or the diversion of other income--is included in the dealers’ calculations.

“Their arguments make no sense to me at all,” said Alexandra Armstrong.

She cautioned that a person shouldn’t carry this to the point of forgoing a really good long-term investment, but she also noted that many of her clients pay cash simply because they are not comfortable with debt.

The tax consequences are another joker in the deck. The tax deduction for ordinary car loans is fading fast, and if the income on your savings is taxable, that makes the situation worse.

Of course, you might be able to use a fully deductible home-equity loan and put your cash into tax-exempt bonds. That would deal with the tax question, but it does not undo what common sense tells you to be true:

You can’t borrow at 11% and save at 8% and make money. If you could, the savings and loan industry wouldn’t be in the shape it’s in.

H. Lynn Hopewell of Hopewell Rembert Advisors Inc. in Falls Church, Va., suggested you think of it this way: You’ve paid cash and are on your way out the door when the car dealer says, “Oh, by the way, we have a bank. Why don’t we lend you money? You can go and put it in another bank and make money.”