Never, ever take out a loan to buy a car – always pay cash. Think of a car as a really bad investment because it is, it is guaranteed to be worth less in the future. Forget about the classic car phenomenon where cars actually appreciate in value, they don’t, they just seem like they do because of inflation. And even if they did actually increase in value, you’d have to keep your car for 25 years or more and work very hard to maintain it over the years. And definitely don’t drive it, that’ll hurt its chances of becoming valuable.

If you wouldn’t borrow money to buy an investment you knew was going to be worth less in the future, you shouldn’t do it with a car. The only reason to buy a car that you can’t afford is for emotional reasons (or worse, you want to impress strangers). If you do that, realize that you are paying a lot for those emotional reasons. And if this is the way you think about all purchases, accept that you will never be financially-sound. That’s okay too, money isn’t the most important thing in life and driving a new BMW is more fun than driving a used Honda, but if you do this you aren’t allowed to complain about your lack of money. :)

If you don’t have the cash for your car, buy a less expensive car that you can pay for with cash. If you don’t have the cash to pay for a new car, buy a used car. If you still don’t have enough cash, find a less expensive car. If you still don’t have enough cash, save until you do. If you don’t want to save, go buy a car that costs more than you can afford, but realize that you’re making a financial mistake, one that will take you a while to recover from, if you can recover from it. And don’t claim that you can’t get a decent car for cheap, eBay “shows”: plenty of decent cars have been sold for as little as $1,000.

Now that you have the cash to buy your car, if you still think a loan is the way to go, keep reading.

For those that do have the cash to pay for a car, the rationale to take out a loan is because you think you can beat the interest rate with other investments. The idea is that if the APR for the car loan is lower than what you could make in another investment, such as the stock market, it’s smarter to invest the money you’d normally put into the car in that investment. The difference in the return on the investment and the interest on the loan is your profit. It works in theory, but of course, it’s risky. Paying cash for your car is risk-free – you are guaranteed to only pay what you paid for the car.

The APR on car loans are typically 6-8% these days and the highest-growth investments are stocks and the stock market does 10% per year. It sounds good except for one thing: the stock market doesn’t do 10% every year, it has done 10% a year on average over 100+ years. Some years it does much worse, some years it does better. 2007, for example, only did 5.49%, 2005 was worse at 4.91% and 2000-2002 were actually negative growth at -9.1%, -11.89% and -22.10%! Other years were better; 2006 did 15.79%, 2004 did 10.88% and 2003 did 28.69%! You can’t ignore the bad years when you have your money invested and you don’t know when those bad years are coming.

bq. If you have a secret investment or a “great stock pick” that you think is guaranteed to do better than the general stock market, great, but what are you doing reading this or even buying a car now? Take all your money, all your family’s money and all your friend’s money and make a fortune so that you can always pay cash for cars in the future! Realistically, you don’t have a sure-thing, so face it, trying to beat your APR with an investment is a gamble.

If you still think that your car loan APR is low enough to make you comfortable trying to beat it, let’s walk through the process to point out some things you may not have considered. The game is that you are taking a pile of cash, investing it somewhere and watching it grow and hoping that it turned into more money than you paid the bank over the years in interest on your loan. Each month, however, you have to make a loan payment. Those payments chip away at the amount you have invested and, of course, the less you have invested, the better your investment has to do to make up for the decrease in your investment.

bq. To be clear: $10 earning 10% gives you $1 in gain, but if you have to pay $1 to your loan, the remaining $9 earning 10% only gives you 90¢. So the $9 has to earn 11.1% to match what the $10 was capable of doing at 10%.

When you’re taking money out of your investment to make your payments you have to pay Capital Gains taxes too, which are 15% of your profit. You probably also have to pay trading fees to sell your investment if you’re invested in the stock market. These can be as high as $30 per trade, which cuts into the amount you have invested and (hopefully) growing, making it even more difficult to beat your loan’s APR. To make matters worse, there’s inflation. If you make an investment and you end up with a gain that didn’t outpace inflation, you’ve still lost money in real terms. If you pay cash for the car, you don’t have this problem because you didn’t invest the money (but you didn’t give yourself a chance to beat inflation, either).

So to beat your car loan with your investment, your investment has to beat 5 things: 1) the loan’s APR, 2) the reduction in capital investment, 3) Capital Gains taxes, 4) trading fees and 5) inflation. A simple spreadsheet can help you add these together to figure out what growth rate your investment would need to achieve to beat all of those and to break-even. I’ve done that for APRs ranging from 1% to 10% and for 3, 5 and 7-year car loans:

h1. 3-year loan:

1% 11%
2% 13%
3% 15%
4% 17%
5% 19%
6% 21%
7% 23%
8% 25%
9% 27%
10% 29%

h1. 5-year loan:

1% 12%
2% 16%
3% 19%
4% 22%
5% 26%
6% 29%
7% 33%
8% 36%
9% 39%
10% 43%

h1. 7-year loan:

1% 14%
2% 19%
3% 24%
4% 28%
5% 33%
6% 38%
7% 43%
8% 47%
9% 52%
10% 56%

What these show is the Total ROI you’d need to make at various APRs and loan lengths. For example, a 5-year loan at 6% would require your investment to earn 29% over 5 years to break-even. Using simple numbers, a 29% ROI means that a $100 investment would need to grow to $129 after 5 years. The amount of the loan, i.e., how expensive the car you’re buying is, doesn’t matter.

Before I continue, for those who think they got a great APR:

bq. 0% (or very low) APRs are more and more common. Before you think the car dealer is really nice or really dumb, the car makers that do this do it because they are having trouble selling their cars, which probably means their cars aren’t very good or their cars are overpriced. If a car is a bad investment, a lousy car is a really bad investment. As far as I know, only GM and Chrysler have ever done this, Toyota and Honda don’t need to. Caveat emptor.

bq. Dealers only give these low APR loans on cars you pay sticker price (or close to it). They do this because they are making their profit now rather than over time. Cars at sticker price have large profit margins built-in. The dealer is trying to fool you into paying more by luring you with a low APR (“Pay attention to my left hand and ignore my right hand!”). Don’t buy a car at sticker price. And definitely don’t pay sticker price just so you can get a low APR. You’re better off negotiating a lower price for the car and paying a higher APR. A lower price also decreases the sales tax you’ll pay.

You should only accept financial risk when you don’t mind losing the money or when you have time to mitigate the risk. How much risk are we talking about?

Here’s a table that shows the returns for the stock market (the S&P 500) for the last 20 years and their total returns, in percentages, for 1, 3, 5 and 7 year spans:

Year 1-year 3-year 5-year 7-year
1988 16.61      
1989 31.69      
1990 -3.10 48.80    
1991 30.47 66.49    
1992 7.62 36.06 108.94  
1993 10.08 54.57 97.24  
1994 1.32 20.03 51.75 133.03
1995 37.58 53.45 115.46 174.94
1996 22.96 71.40 103.06 156.71
1997 33.36 125.60 151.62 253.31
1998 28.58 110.84 193.91 248.19
1999 21.04 107.55 251.11 291.61
2000 -9.10 41.47 131.98 223.37
2001 -11.89 -3.06 66.23 181.21
2002 -22.10 -37.61 -2.90 59.23
2003 28.69 -11.67 -2.82 66.64
2004 10.88 11.15 -10.98 38.55
2005 4.91 49.69 2.75 13.05
2006 15.79 34.70 35.03 8.15
2007 5.49 28.15 82.85 25.51

For example, looking at 1999, the S&P 500 return for the year was 21.04%, 107.55% for the 3-years ending in 1999, 251.11% for the 5 years ending in 1999 and 291.61% for the 7 years ending in 1999. (Before you get too excited about the years leading up to 1999, that was the dot-com bubble years).

To gauge the historic risk for yourself, look at the tables above to figure out what the total return you’d need to achieve for your loan’s APR and length. Using these tables, you can quickly determine the probability that you will be able to match your loan’s APR. Of course, the past is not a good indicator of future stock market performance, but it’s all we got. You’ll find that the chances you’ll be successful range from 69% to 86%, meaning that, depending on your APR and your loan length, you have a fairly good chance of matching your loan’s APR, but also a good chance of not matching it. That’s risk. Of course, if you pay cash there is no risk, you are guaranteed to break-even.

Now, remember, we’re talking only about breaking even. There’s little reason to take on any risk unless there’s the chance of a significant gain, right? To have a higher gain, you need to risk more, i.e., buy a more expensive car. If your car is not expensive, even a good gain above paying off the interest on the loan doesn’t amount to much, and is probably not worth the risk. You’ll have to be your own judge of that.

So the summary is: if you are wealthy enough to buy an expensive car, you have the cash to do it and enjoy risking a lot of money, take out a car loan and have fun. If you’re anyone else, don’t do it.