Will I need money down?

Or, the pros and cons of no-money-down car loans

Will you need money down? In a word, “No.” But that doesn’t tell the whole story.

While money down on a car loan is not always necessary, it is always recommended. Why? That’s what we’re here for. So take a few minutes to learn what’s best for you and your situation. We’re sure it’ll save you a few headaches—it may also save you thousands of dollars.

What is a down payment?

If we’re starting from the very beginning, we should start by defining a down payment. A down payment is something of monetary value that covers the gap between the cost of your vehicle and the amount of financing you receive. For example, if you plan to purchase a $20,000 car and finance $15,000 of that purchase, you’ll need a $5,000 down payment. Simple, right?

In most cases, your down payment will be made in cash. However, there are other alternatives. If you’re trading in an existing vehicle, the value of that vehicle can count toward your down payment. Just know that the Canadian Black Book value of your car may be more than a dealer can reasonably offer, especially if your car is in sub-optimal condition. Selling your car privately and bringing the cash as a down payment may be a better option.

Some lenders accept other items of value, from home stereo equipment to power tools. These exchanges are less common, but the principle remains the same: The dealer needs something that can be readily converted into cash.

The purpose of a down payment

If you can obtain financing for the full amount of your vehicle, why shouldn’t you take it? The answer requires a bit of explanation. For some customers, 100 percent financing is their only opportunity to drive away in a car—they have no cash reserves or other items of value to exchange.

Risks

But a no-down-payment car purchase opens the door to other, negative possibilities, namely the potential to become “upside down” on your car loan. This occurs when you owe more money than your car is worth. It is the greatest risk of no-down-payment auto loans.

It’s easy to get upside down on a new car loan because the moment you drive off the lot, your vehicle loses its value (depreciates) by almost 20 percent. So, returning to our earlier example, a new car purchased for $20,000 is worth just $16,000 as soon as you leave the dealership. (You can calculate a more specific depreciation by dividing the trade-in value of your car after one year of ownership by the purchase price.) So, if you finance the entire purchase, you’ll still owe $20,000 on a vehicle worth $4,000 less.

If your car is stolen or totaled in an accident, most insurance companies reimburse you for the current value of the car, not its original purchase price. (Some policies offer new-car replacement within the first few years of ownership.) Likewise, if you lose your job and need to sell your car, you may receive a fair market price without being able to pay back your lender fully. You’ll be upside down on your car loan.

Benefits

On the flip side, a reasonable down payment may provide near-immediate equity in your vehicle, allowing you, at any point, to trade in your existing vehicle for a new one without significant out-of-pocket expenses.

Lenders like to see a down payment, even a small one, for several reasons. Most obviously, it decreases their risk—they’re lending a smaller amount of money. But it also shows commitment on the part of the buyer, as you’ve invested your own cash into the new vehicle. This commitment, in turn, has been shown to reduce the risk of default, making the lender more likely to provide a better interest rate. Combine an improved interest rate with a smaller loan amount, and you may save hundreds if not thousands of dollars over the term of your loan!

If you have poor credit history, a down payment may be required to obtain a vehicle. Still, every situation is unique. A steady place of residence and work history may allow you to qualify despite blemishes in your financial background.

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How much money should you put down?

Most financial experts recommend a down payment of 20 percent to cover the initial depreciation of your new car. As you drive off the lot, the amount of money financed for your car purchase will equal your vehicle’s value.

Still, recent history has shown that the average car buyer puts down less than 20 percent on a new vehicle, with average down payments in 2013 hovering around 12 percent for car buyers. There are two theories on why the down payment has fallen short of recommendations. For one, the cost of a new vehicle has risen faster than the median wage, making it difficult for many families to keep pace. Second, national fiscal policy has maintained low interest rates to help the global economy recover from the financial crisis of the late 2000s, making financing more attractive.

Because used cars have already experienced this immediate depreciation, they can be a much safer alternative for any car buyer, especially for those financing 100 percent of the purchase. You’re less likely to be underwater with a used car purchase, and, even if you are, your financial exposure will be less. Experts agree that a down payment of 10 percent is sufficient to protect yourself when buying a used car, which may seem more feasible.

GAP insurance provides a third alternative. For a few hundred dollars, GAP insurance insures you against the difference between what insurance companies pay for in the event of a damaged or stolen car and what you may still owe your lender.

So, if you have plenty of cash, why not increase your down payment to 30 or 40 percent? Or even pay for the car outright? For some people, that may be the right decision. Debt always incurs risk, even in stable financial circumstances. But cars are also depreciating assets. Unlike a home, they continually lose their value. Car buyers able to obtain the best interest rates may find that investing unspent cash in stocks or bonds returns greater value than sinking that cash into a car.

Additionally, if money is tighter, saving cash for your emergency fund makes more sense than locking it into a vehicle, where it remains inaccessible unless you sell your car.

Lenders, down payments, credit scores, interest rates, and loan duration

You shouldn’t consider a down payment in isolation of other financing factors. At the end of the day, getting the right financing depends on your lender, down payment, credit score, interest rate, and loan duration.

The lender

The first aspect, the lender, is simple to understand. You need a partner that understands your situation and has your best interests in mind. Also, like any other purchase, shopping around makes sense. Take the time to find the best lender to meet your needs.

Compared to banks, dealerships often are more willing to extend credit to buyers because they have the added incentive of selling a car. Additionally, local businesses, whether dealerships or banks, will have a better understanding of the local economy and the ability to empathize with local hardships, like large-scale job layoffs at a city factory.

Down payment

Your down payment is the second key factor. In addition to preventing you from becoming upside down on your loan, your down payment reduces the total amount you need to finance, which may help you secure lower monthly payments. It’s intuitive: Your monthly payments are the amount of the loan (plus interest) divided by the period of repayment. Financing a smaller portion of the purchase price leads to lower monthly payments. On average, every $1000 you put toward a down payment reduces your monthly payment by about $20.

Likewise, a shorter loan duration means paying less overall interest to the lender. However, be aware that a shorter term also results in higher monthly payments because the loan amount is divided by fewer months. Ultimately, however, it creates a lower total cost.

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Credit score, interest rates, and loan duration

Your credit score affects your interest rate, and a higher credit score will give you access to the lowest interest rates, which may be as low as 0.00%. The interest rate you receive depends on your personal financial history as well as broader economic policy. Ultimately, the interest rate is the price you pay the lender for the privilege of borrowing money.

However, it’s important to take into account the annual percentage rate (APR) of your auto loan, not just the interest rate. The APR is the total finance charge of your loan expressed as an annual rate. It provides a fuller understanding of out-of-pocket expenses, which may include document preparation fees, title fees, filing fees, and warranty charges, rather than focusing on the interest rate alone.

This is also where interest rate and loan duration intersect. A lower interest rate means you’ll pay less interest, but monthly payments may be high, depending on the duration of the loan. A longer loan duration means a higher interest rate and greater overall expense but smaller monthly payments. Let’s break it down:

  1. 1. The interest rate is higher because it represents an extended risk to the lender.
  2. 2. The overall expense is greater because you’re paying monthly interest for a longer period of time.
  3. 3. The monthly payment is smaller because you’re dividing the amount of your loan by a larger number of months.

This final point is key because many buyers simply see a smaller monthly payment in a financing offer and jump on it—even as it locks them into thousands of dollars of additional interest. Most auto loan durations are for 36, 48, or 60 months. Some may be as long as 72 or 84 months, but these should be avoided, if at all possible.

Why? Here’s an example. A $20,000 loan for 72 months at 7 percent interest would cost you about $4550 in interest. That’s almost three times the interest you would pay for a 3-year, 5-percent loan. If you need a 72-month loan to pay off your car purchase, you should probably consider a less expensive car.

Apart from a higher interest rate and greater total interest, you may also expose yourself to the risk of looking for a new car before paying off your existing vehicle. Most North Americans keep their cars for about 4.5 years, and it doesn’t make any sense to pay back a loan for months or years after discarding a vehicle.

Some lenders allow car buyers to roll an existing loan into their next vehicle purchase, but this can put you upside down in a hurry—and for longer. Remember: No matter how you set up your loan, you will pay for the car one way or another. Don’t let a low monthly payment obscure the fact that a vehicle may still be out of your budget.

Is a long-term loan ever a good idea? Only for those with current financial stability but an uncertain economic future. Securing a long-term loan at a low interest rate can provide protection down the road. In the near term, pay off the loan as quickly as possible. Then, if your income later declines, you’ll have a lesser burden of monthly auto payments. Even adding $20 or $30 to your regular monthly payment may save hundreds in finance charges over time.

If you are taking out a long-term auto loan, make sure you choose a car that has high reliability and longevity. That way, you give yourself the best shot at avoiding car replacement before the loan is repaid.

When no down payment may be the right choice

There are best practices when it comes to financial planning, and then there are life’s unexpected events. We know that even savvy, spend-thrift people can run into financial trouble. And that’s why we recognize that there may be a time when no down payment is the right choice—because it may be the only choice.

So when is it the right choice?

  1. 1. When your current vehicle has become unusable
  2. 2. Personal transportation is still necessary
  3. 3. You have no way to provide a down payment on your next vehicle
  4. 4. And you’re willing to assume more risk with your car loan to preserve emergency savings for repairs to your home or medical expenses—the inflexible, urgent needs.

But, as you may have already noticed, a no-down-payment loan is a way to manage a difficult situation, not an ideal scenario for borrowers. Remember, too, that “no down payment” doesn’t mean no cost to the buyer. Some lenders lure buyers to their businesses with promises of no down payment only to add fees and closing costs to the purchase. These costs can be particularly onerous because, unlike a down payment, the out-of-pocket money goes straight to the lender rather than paying off your vehicle.

It’s another reason why taking a few months to save up money for even a small down payment can be well worth the wait. It protects you from being upside down on your loan or falling victim to unfavorable, even predatory lending practices.

When you’re ready for a detailed analysis that takes into account your unique financial situation and transportation needs, just get in touch or take a moment to fill out our credit application. Find out how we can work together to find a solution that works for your life and your budget.

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