In an ideal world, no one would finance anything. However, we know that the world isn’t perfect, and it’s estimated that over 70% of consumers finance their new automobile purchases. Of course, you’ve heard it before: you should put 20% down when financing a new car. That sounds easy enough, but with the average price of a new light vehicle in the US topping $31,000+, this amounts to a cash down payment of $6200. That’s a serious chunk of change for just about anybody. It can quickly become tempting to forgo this cash outlay, especially if your credit, dealer, and lender align to make a “no money down” deal possible. Many consumers use the rationale that they would rather have this money in their own bank account, collecting interest, instead of being wasted on a depreciating asset. I’m not here to debunk that logic, but there is more to the story. There are quite a few ramifications that come with financing a car with no down payment, some of them lesser known than others.
The loan-to-value ratio (LTV) is one of the factors that will determine your interest rate. This ratio is, in layman’s terms, the percentage of the vehicle being financed. In a simplified scenario, if you put down 20% of the vehicle’s purchase price, then you would have an LTV of roughly 80%. In reality, it’s a bit more complicated than that, but you get the idea. In any case, a higher LTV results in a higher rate of interest. Many consumers actually end up with LTV’s in excess of 100%, because they either a) have no payment and additional fees, or b) they roll an old loan into a new one. Either way, you can see that a lack of down payment could lead to higher rates of interest, and we all know that higher interest can cost you a LOT over the long term.
Oh, negative equity. Otherwise known as being “upside down” or “underwater.” This is never a good place to be, and with vehicles–especially new ones–it’s a huge risk. Why? Because cars and trucks are some of the fastest-depreciating assets money can buy. Your new car will lose 20% of its value the second it leaves the lot, and 30% by the end of the first year of ownership. Used vehicles are slightly better, but they still lose approximately 15% of their residual value per year. This can backfire on your in three scenarios:
- Your car is totaled in an accident. Even if you have full coverage insurance, it only pays what the car was worth on the day it was wrecked. You will still be on the hook for the remaining loan balance, known as a “deficiency balance.”
- Your car is repossessed. If you begin missing payments and your lender recovers the vehicle through voluntary or involuntary repossession, you will still have to pay the deficiency balance. In some states, if you refuse to pay this, the lender can sue for a judgment and garnish your wages.
- You trade in your car before it’s fully paid off. This is the most common scenario. Most consumers trade in their vehicles before they’ve paid them off. If there’s a deficiency balance, the dealer will “roll” this into the new loan. Now you have SERIOUS negative equity issues.
Negative equity is as much a risk for the lender as it is for you. After all, it means there’s a greater risk that they won’t be able to recoup their loss if the vehicle is repossessed or wrecked. For this reason, if a lender sees that negative equity is going to be an issue, they may require you to purchase GAP insurance. Short for “Guaranteed Auto Protection,” this typically costs an additional $600-$800 if paid at once, and 5-6% of your insurance premium if billed monthly. Keep in mind, you cannot finance a car without full coverage insurance, and GAP insurance will cost you that much more.
The Cash Option
Of course, if you have the cash for a down payment, you might consider putting it toward the cash purchase of an affordable used vehicle. My friend Jerry Coffey has delved deeply into the cash vs financing question in the past, and he isn’t the only one in the personal finance blogosphere to tackle this debate. For instance, Financial Samurai recommends the 1/10 rule for buying a car: don’t spend more than 10% of your gross annual income on a vehicle. Of course, this is great in theory but isn’t always realistic, especially if you make less than $50,000 a year. I can tell you this from personal experience. My current daily driver is a 1985 BMW on which I spent much less than 10% of my income: just $900! However, it could be a real nightmare to drive something of this vintage and condition if you aren’t mechanically inclined. I just drove it a whopping 75-mile round-trip, but of course I had to pull a new alternator bracket from a junkyard to replace one that broke on the trip down. Unless you are up for these kinds of headaches, spending something closer to 20-25% of your annual income might be better. In Financial Samurai’s book, this still makes you a “sound thinker who eschews consumerism,” and depending on your income, is still probably enough to get you a late model Corolla, Yaris, Civic, Versa, or similar compact or subcompact.
Like many things in life, the “no down payment car loan” sounds better than it is. Once you factor in all of the negatives, it doesn’t seem like such a good deal.
About the author: Taylor is the founder of AutoFoundry.com, a fast-growing automotive blog, and he also writes for corporate financial sites like Motive Auto Finance.