Paying Cash for a Vehicle

We explained the opportunity cost that you face if you pay for a vehicle with cash. Money that you yank out of a savings or investment account to pay for a vehicle means your investment principal is smaller.

The advantage of using cash, however, is that you save hundreds or thousands of dollars of interest expense. After all, interest on auto loans (and other forms of consumer debt such as credit cards) is not tax-deductible.

You should evaluate carefully the trade-off in saving interest expense with the impact on your savings. In some cases, it may be cheaper to borrow to pay for a vehicle.

A rule of thumb is if the after-tax interest rate you pay on a loan is greater than the after-tax interest rate you earn on an investment, you may pay with cash. You save more in interest over the loan term than you earn over the same period (ignoring compounding and reinvesting).

However, you should consider the loss of financial flexibility that accompanies that decision. For example, you likely don't want to raid a tax-advantaged account or deplete an emergency fund for the sake of raising cash.

Paying cash instead of leasing is a more difficult comparison. After all, paying with cash means that you take ownership of the vehicle immediately. Leasing is only a means of making payments towards the option to buy the vehicle. At the end of the lease term, a lease gives you the option to buy at the vehicle's residual value.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.

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