Deciding on the <i> Other </i> Car Options

Deals, deals, deals, as new car salesmen often say these days. But which one should you pick?

Buyers today face a greater variety of options in buying cars, ranging from various leasing arrangements to subsidized loans offered by manufacturers to cash-back rebates.

During the 1980s, people bought everything on credit, certainly cars more than almost any other durable good. But people are burned out on debt.

Many consumers never gave up on cash as a way to buy a car. Today, 43% of new car buyers just pay cash. About 35% take out bank or credit union loans and the balance get financing from a dealer or auto manufacturer.

But what are the economics of cash? The conventional wisdom is that if your after-tax cost of borrowing is greater than the after-tax return you can earn by investing your money, then you should pay cash, said Peter Levy, president of the automotive market research firm IntelliChoice.

Levy, who authors the “Complete Cost Car Guide,” said that current interest rates and inflation rates favor paying cash. His book provides a useful work sheet for the calculation.

But the decision in the real world involves a number of other assumptions that can change the results dramatically. It isn’t easy to follow and the analysis below is unconventional, but it seems to favor borrowing over cash.

Let’s say you buy a new car for $20,000, using a 7.5% loan offered by the manufacturer. You would be paying nearly $484 monthly for 48 months, and over the loan’s term you would pay out $23,212.

Alternatively, let’s say you select the option of taking a $1,000 cash rebate offered by the same auto maker and scrape together your savings to pay the $19,000 balance. Then, you set up a saving program to replace the $19,000 over the next four years.

Each month, assume you can earn a generous 8%, amounting to 5.2% after you pay income taxes. You will have to save $357 per month over the next four years, amounting to an outlay $17,136.

Thus, over the four-year period, it looks like you are $6,076 ahead by paying cash.

But there is a hitch. You obviously would have earned interest on the $19,000 if you hadn’t used it to buy a car. Assuming you would get the same 5.2% yield if you left the money in savings (and borrowed the money for the car), you would have earned $4,385 at the end of four years. That leaves you $1,693 ahead on the cash option.

Well, you say that’s not much, but the picture gets worse. In four years, the $19,000 that you save up will not buy a car because inflation will have forced up prices, and there might not be a rebate.

So, let’s figure that today’s $20,000 car will cost $23,400 in four years (with 4% inflation). Now you will have to save $440 monthly for an outlay at the end of four years of $21,200 (and earned interest of $2,200). Compared to the loan, you are now underwater by some $2,373 because of your bright idea to pay cash.

And the analysis is even more persuasive if you can borrow money on an equity line of credit against your home, which is tax-deductible.

Levy and other experts say this sort of approach is flawed, because it isn’t fair to compare a loan on today’s lower-cost car against savings for a higher-cost car in four years. After all, if you buy your next car with a loan, your loan payments will be higher then. But if you pay cash again, you will have to save even more to offset inflation again.

The problem with saving to buy a new car is that you are battling two powerful forces: inflation in the price of the car and the tax penalty for saving money.