Americans aren’t bashful when it comes to borrowing money to buy a car. About 85% of buyers take out a loan to pay for their new ride, according to Experian Automotive. But suppose you have enough saved up to pay in cash — is that the smartest move? Or does financing the purchase with today’s low interest rates and investing your money in the stock market make more sense?
To answer those questions, NerdWallet crunched the numbers for a hypothetical consumer: A buyer with enough savings to spend $25,000 on a F-150 XL pickup, which is part of the Ford F-Series, the best-selling line of vehicles in the U.S. In our scenario, the buyer would spend $5,000 of the money in the savings account on the truck and take out a $20,000 five-year loan at a 2% APR to cover the rest. When looking for a loan, be sure to shop around for the best APR — credit unions will often provide the lowest rates.
A potential payoff
The buyer’s remaining $20,000 would be invested in an index fund that tracks Standard & Poor’s 500 index, which has a 10-year annualized rate of return of 7.7% as of July. The buyer would then take money out of the index fund each month to make payments on the auto loan.
So where does that leave the buyer? After paying the final loan installment and factoring in capital gains taxes, the buyer could be left with about $2,723 in the fund, or an 11% savings on the price of the new pickup.
A few words of warning
Not everybody can afford to pay for a new car in cash. And even for those who can, the peace of mind that comes with being debt-free may be more valuable than the potential payoff of taking out a loan and investing in the stock market. Others might not mind the risk and extra legwork of getting a loan and investing in a fund, so long as the potential return is substantial.
There are a number of caveats that should be mentioned: First, past performance of the stock market isn’t a reliable indicator of future performance. Should the stock market nosedive, you could lose much of your investment, and you’ll still be on the hook for the $20,000 loan.
Also, consider the annual percentage rate on your loan carefully. The lower the APR, the more you’ll save over the life of a five-year loan. But again, there are no guarantees on how the stock market will perform. Even with a low APR, the risk of investing may not be worth it.
Check out the chart below to see how the APR could affect the potential savings, assuming the S&P 500 had a 10-year annualized rate of return of 7.7%.
|Auto loan APR||Five-year potential savings|
You could also decide to leave your $2,723 in the index fund for another five years. Of course, the value of your investment could fall, but assuming the 10-year annualized rate of return of 7.7%, that would bring it to $3,997. Stretch it to 20 years and it could grow to $12,639. That’s enough to pay for a lavish family vacation — or another car.
Victoria Simons is a senior analyst covering loans and insurance for NerdWallet.
Infographic by Jazeena Pineda.
Image via iStock.