Wouldn't it be great to buy a nice new car -- or a nice nearly new one -- and not have to make payments on it? More and more people are doing exactly that -- by paying cash for their new cars.

Why? Well, it's partly due to the gains made by the stock market in recent years, which have given more people the means to contemplate buying without borrowing. And it's partly due to changing sales patterns in the face of rising gas prices and environmental concerns.

While hybrids and high-tech diesels have gotten the bulk of the media's attention, automakers Honda (NYSE:HMC) and Toyota (NYSE:TM) have seen sales of their subcompact Fit and Yaris models surge in the last couple of years. In addition to being more efficient than large cars, small cars are cheaper: A well-equipped Fit runs around $15,000. That's still a lot of money, but it's a lot less than the $25,000 or so you might expect to spend on an Accord, Camry, or other similar mainstream sedan -- enough that a cash deal suddenly looks possible.

Tempting, isn't it? Hold on a minute. Before you write that check, ponder the opportunity costs. Paying cash has some definite advantages, but if you're cashing out an investment to do it, you might want to consider what you're giving up, too.

The good news
Many personal finance writers -- particularly those who take an Exorcist-inspired approach to consumer debt in general -- will tell you that paying cash for your next car is the only way to go. It certainly has some huge advantages:

  • No financing costs.
  • No worries about having bought more car than you can afford.
  • No fear of being "upside down" -- of owing more than the car's worth.
  • No monthly payment to budget around, no credit exposure, no hassle.

"Those seem pretty compelling," I hear you saying, "so what could possibly be the downside?" I'm glad you asked.

Where's the money coming from?
First of all, let's be clear. Paying cash for a car isn't likely to ever be a really bad move. It's certainly better than some financing options. But as with any large purchase, particularly a large purchase where it won't be easy to get (all of) your money back, it's worth asking yourself a couple of questions first:

  • Do I understand all my options?
  • What's the opportunity cost? What am I giving up to make this purchase?

That money has to come from somewhere, right? If you're like most people considering a cash deal, you'll have to sell something from your investment account to come up with enough money. Pulling that money out of an index fund earning 10% (for instance) means that, in effect, that 10% in foregone return becomes part of the price of the car. Whoa.

"But that's not far off what I'd pay on the loan, and it's worth it to avoid the hassle," I hear you saying. Not necessarily. While big banks like Bank of America (NYSE:BAC) or Wells Fargo (NYSE:WFC) want you to believe that they're the best stop for financing your purchase, you have plenty of other options that might be better.

A new car dealer is all but certain to offer you a competitive financing package -- possibly even a crazy-low-interest one, if the model you're buying is a slow seller. He'll also be much more amenable to a discount off the total price if he knows he's going to make some of that money back on the financing. You might well be spending 10% (the index fund return you'll be giving up) to save as little as 0.9% (on dealer financing), while making the price negotiation harder for yourself.

Suddenly, the "only way to go" doesn't look so clearly superior, does it?

The upshot
Generally speaking, if you can afford to pay cash for a new car, it's never a truly awful idea -- unless the cash is coming out of your emergency fund or was otherwise earmarked for other needs, of course. But look at the whole picture. If you have to sell a stock investment, it may be a money-losing move. And if you do decide to pay cash, don't tell the dealer until the last possible moment. Ideally, wait until the dealer's finance and insurance manager is handing you the loan papers at the closing.

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Fool contributor and car nut John Rosevear doesn't own any of the stocks mentioned above. Bank of America is an Income Investor recommendation. The Fool's disclosure policy is happy to serve you, whether you choose cash, check, or e-z credit.