Financing Options for Buying a Car

If you will be purchasing the car with a loan, be aware of your financing options. Consider options such as a home equity line of credit for potential tax deductions and a relatively low interest rate, or 401(k) loans for a guaranteed-to-be-approved-loan and a very competitive interest rate. Many banks, credit unions, and other financial institutions offer favorable interest rates on car loans. The dealer can often get you a loan, but you may be able to get better terms if you shop for financing before you choose your car.

This way, you will be able to evaluate the terms offered by the dealer and compare them to terms offered elsewhere. If the manufacturer offers a special financing deal on the car you choose, these will probably be the best terms available.

Be aware, that in order to take advantage of this low rate there may be special requirements or restrictions. For example, you may have to make a particularly large down payment.

Should you pay cash for a car if you can, or is it better to take a loan and invest the cash?

You're buying a car for $20,000. You can either pay cash or borrow $20,000 at 9 percent interest for 48 months. Assume that if you borrow the money, you will invest your $20,000 and earn a 7 percent after-tax rate of return. Also assume that if you pay cash, you'll invest the money you would otherwise have used to repay the loan each month. This investment will also earn a 7 percent after-tax rate of return.

If you borrow $20,000 at 9 percent interest for 48 months, your monthly payment will be $498. The total of your payments over the term of the loan will be $23,904. During this same time, your cash (invested at 7 percent after-tax) would grow to $26,216.

If you pay cash for the car instead, you would invest $498 per month instead of making payments on the car loan. In total, you would invest $23,904. Assuming a 7 percent after-tax rate of return, your investment would grow to $27,374 after 48 months.

In this example, paying cash was a better choice because the return on your investment was lower than the auto loan interest rate. If you can get a great interest rate, taking a loan and investing the cash will put you further ahead. The key to determining your best course of action lies in calculating the total cost of repaying the loan (or repaying yourself) and comparing this to the expected return on your investment.

Can you use a loan from a family member to buy a car?

Sometimes a family member will lend you money to buy a car, often with little or no interest charged. However, before taking a low or no-interest loan from a family member, it's important to understand the potential tax implications.

Interest-free and low-interest loans from a family member may have gift tax implications for the lender. In addition, the interest on a loan is considered taxable income to the person who lends the money. If no interest is charged or the rate is unusually low, the Internal Revenue Service may impute interest. This means that the lender must pay taxes as though interest is being paid at a fair rate. Loans of $10,000 or less generally aren't subject to imputed interest. Some exceptions also apply to loans over $10,000, if the borrower's net investment income is minimal. Since this calculation can be somewhat complex, you may wish to consult a tax professional in determining the income and gift tax consequences of an interest-free or low-interest loan.

Can you use a home equity loan or line of credit to purchase a car?

Generally, you can use a home equity loan or line of credit to purchase a car. The advantage to this type of financing is that, because the loan is secured by your home, the interest is usually tax deductible (although you should consult a tax professional before taking a home equity loan for this purpose). The disadvantage is that if you don't repay the loan as agreed, you could lose your home.

Can you use a 401(k) or 403(b) loan to purchase a car?

If you have sufficient dollars in your employer-sponsored retirement plan, check with the plan administrator to determine whether you're allowed a loan from the plan. Generally, plans allow loans from $500 up to $50,000 from your account. The percentage you're allowed to borrow often varies from 50 percent to 80 percent of the plan value. The interest rates are usually similar to home equity loan rates, but the good news is that you're paying yourself that interest. The bad news is: if the stock market increases tremendously while you have a loan outstanding, you miss out on the growth on that portion of the account balance that has been borrowed.

Caution: If you don't repay the loan within five years or if you miss payments, the loan may be treated as a distribution for income tax purposes and thus may be included in your income and subject to the early withdrawal penalty. If you leave your employer, the loan could also be called due.

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