How to Pay for a Car

Nearly 90% of American households own a vehicle, according to Pew surveys -- which is one of the highest rates of vehicle ownership in the world. Many American households don't own these vehicles outright, though. Instead, the majority of all new and used cars in the United States are financed.

if you're getting ready to buy a car, either now or in the future, it's important to be smart about how you'll pay for it. While most people default to a car loan, this is not necessarily the best approach for everyone. And those who do finance a car often make common car loan mistakes, such as borrowing too much or for too long a time.

This guide will provide insight into each of your payment options, so you can make the most informed choice about what's best for your situation. You'll also learn some caveats about car financing to keep in mind so that you don't end up with a car loan that compromises your financial security.

Ways to pay for a car

When it comes time to buy a vehicle, you have a number of options, including:

• Paying cash
• Paying for some or all of the car with a credit card
• Taking out a car loan

There are pros and cons to each of these options. And if you decide you want to charge a car on a credit card or take out a car loan, be smart about where and how you secure financing. Let's take a closer look at each of these options.

Paying cash for a vehicle

Paying cash is the best way to pay for a car. That's because cars are not investments that go up in value -- they are depreciating assets that lose value as soon as you drive them off the lot. And they continue to lose value the entire time you drive them. If you take out a car loan, you're now paying interest on an asset that is already worth less than what you paid for it. This interest increases your cost of ownership of the vehicle.

In 2018, the average interest rate on a car loan for the purchase of a new vehicle was 6.13%, and the average interest rate on a car loan for the purchase of a used vehicle was 9.59%, according to Experian. The average amount borrowed for a new vehicle was $31,722, and the average amount borrowed for a used vehicle was $20,077. If you borrow $31,722 at 6.13% for 68 months (around the average loan term for a new car), you'd pay back a total of $37,630. That's almost $6,000 in interest cost over 5 1/2 years.

The only downside of paying cash for a vehicle is that doing so ties up money that could otherwise be invested or used for other purposes. For example, if you have high-interest debt, such as credit card debt, you are better off paying off that debt first before trying to buy a car in cash. Since the interest rate on car loans tends to be lower than interest paid on credit cards, personal loans, and certain other types of consumer loans, it wouldn't make sense to pay cash for a car while carrying a balance on other loans at a higher rate.

You also don't want to pay cash for a car if you aren't contributing at least enough money to a 401(k) to maximize your employer match. After all, doing so would be passing up free money.

But outside of situations in which you have high-interest debt or aren't contributing enough to retirement savings, it usually doesn't make sense to put extra money into investing rather than paying cash for a car -- unless you can qualify for a car loan at a very low interest rate. If you'd be paying 6.13% or more in interest to borrow for your vehicle, you're getting a guaranteed return on investment of 6.13% or greater when you pay cash. While you might be able to do a little better investing in the stock market, there's no guarantee of that. And car loan interest -- unlike mortgage and student loan interest -- is not tax deductible.

How to pay cash for a vehicle

Unfortunately, there's one obvious reason most people don't pay cash for a vehicle: They don't have the money to do so. It can be hard to save up a substantial sum of money to buy a car outright. But there are ways to do it.

First and foremost, start by keeping your current car longer. The average length of ownership of a new vehicle is 79.3 months, according to IHS Markit -- which is about 6.6 years. But the average age of light vehicles in operation in the U.S. is 11.8 years. That means many new car owners get rid of their cars when their vehicles still have considerable life left in them.

If you keep your car for several years after you've paid off your current car loan, you can keep making the monthly payments to yourself instead of to the lender. Put that money into a savings account earmarked to buy your next vehicle. In our above example of a $31,722 car loan at 6.13%, your monthly payment on the car would be $553 per month. If you drive your car for four years after your loan has been paid off but keep making this $553 monthly payment into a savings account, this would give you $26,544 in savings by the time you're ready to buy your next car. You could afford to buy a fairly nice used car for this amount of money -- paying with cash.

If you keep this cycle up, making car payments to yourself until you've saved up enough to pay for a vehicle in cash, you'll never have to borrow for a car again. And you should have some extra money to put into savings, too, especially if you drive that car you bought with cash for as long as you can.

Paying for a car with a credit card

Another option that may be available to you is to charge some or all of the cost of a car on a credit card. Charging the car on a credit card has a big benefit if you pay off the card in full when the statement comes. You can earn substantial rewards points or cash back if your credit card is a rewards card. If you get 1.5% cash back on your card and charge a $30,000 car, you'd get $450 in cash back.

Unfortunately, buying a car with a credit card isn't always possible. Some dealers place caps on the amount you can charge, such as limiting you to putting $5,000 of your car's cost on your card. Others allow you to charge the entire amount, particularly if you have a credit card with a dealer brand -- but you'd need to shop around to find a dealer that allows that. You'll also be limited by your line of credit. If you have just a $5,000 credit limit on your card, you aren't going to be able to charge the full amount you'd owe on the car.

However, even if you can only charge part of the car's cost on your credit card, the points or rewards you could earn are still a nice perk -- provided you can pay off the bill in full. You should not charge any part of your car on a credit card if you do not have the cash to pay off what you've charged before you start incurring interest costs. Interest on credit cards far exceeds any rewards earned, and the interest rate on a credit card is usually well above the rate you'd be charged on an auto loan or a personal loan.

Unfortunately, it's also important to note that paying for a car with a credit card could be bad for your credit score, especially if you max out a credit card by doing so. One of the most important components of your credit score is your credit utilization ratio, which compares your card balance to credit available. If you have a $20,000 credit limit and put $10,000 toward your car on your credit card, your credit utilization ratio would be calculated as $10,000 divided by $20,000 -- or 50%. A credit utilization ratio above 30% will lower your credit score. Getting an auto loan, on the other hand, could raise your score if you pay it responsibly, because you'll have a broader mix of different kinds of credit on your report.

Paying for a car with a credit card balance transfer check

Another way you could pay for a car using your credit card is if your credit card offers you balance transfer checks. Balance transfer checks are checks your card issuer provides that are intended for use in paying off high-interest debt by transferring it to your card. But some card issuers actually just give you a check you can deposit in your bank account. If that's the case with your card, you may be able to write yourself a check for several thousand dollars -- up to your balance transfer limit -- and use that money to pay for some or all of your vehicle.

One benefit of doing this is that there's often a special low promotional interest rate attached to these balance transfer checks. Typically, you'll be charged 0% for a certain number of months, such as 12 or 15 months. If you're able to get a balance transfer check with a special 0% promotional rate for 15 months, you could pay off your car over that time without incurring any interest at all.

Often, there's a fee for balance transfers, though. For example, you may be charged a 3% fee or 4% fee, so you'd pay 3% or 4% of the amount you write the check for. Still, paying 3% or 4% in exchange for a 15-month interest-free loan could still be a cheaper way to borrow than getting an auto loan.

The caveat, though, is that you need to make sure you can pay off the debt by the time the 0% rate expires. Otherwise, you could end up owing a lot of money at the standard interest rate on your credit card -- which, again, is well above typical auto loan or personal loan rates. Don't count on being able to transfer the balance again at the end of the promotional period, as this isn't always a guarantee.

It's also important not to confuse balance transfers with cash advances. You could get a cash advance check from your credit card company, but cash advances typically charge up-front fees and have a very high interest rate. Avoid them, and never pay for a car with a cash advance.

Taking out a car loan to buy a car

One of the most common ways to finance a car is to take out a car loan. In fact, according to Experian, 85.1% of new cars and 53.6% of used cars in 2018 were financed. There are some benefits to taking out car loans, including the fact that car loans typically have lower interest rates than credit cards or personal loans.

Car loans are secured loans, which means the loans are backed by collateral, and there's less risk for the lender. The car is the collateral when you take out a car loan. If you don't make payments, the lender has the right to repossess, or take back, the vehicle. The lender has a legal ownership interest in the car until the loan is paid off in full. Repossessing a vehicle in most states is quick and simple for the lender. In fact, it may be possible for a lender to repossess the car without going to court and with little notice to the owner.

While car loans are common, it's important to be smart about how you borrow with a loan. That means choosing the right loan term, not borrowing more than you can afford to pay back, making a hefty down payment, and making sure you have sufficient insurance to cover you in case the car is totaled before your loan is paid off.

How much should you borrow for a car?

Because cars are depreciating assets that go down in value, you shouldn't borrow more than necessary to fund a safe, reliable vehicle. Keeping your car loan cost as low as possible allows you to reduce total interest you pay and leaves you more money for other financial goals.

Most financial experts recommend that transportation costs, in total, take up no more than 15% of your income. But transportation costs don't just include your car loan -- you also have to factor in gas, maintenance, repairs, and registration costs. So your car loan payment should take up absolutely no more than 10% of your monthly income at most. This is 10% of your take-home pay, or after-tax income.

Another way to determine how much you can borrow is to make a detailed budget. Factor in spending on essentials, such as housing and food, as well as spending on entertainment. And budget to save at least 15% of your income (ideally closer to 20%). Once you've made a budget to see how your spending and saving match up with your income, see how much you have left over to put toward a car payment.

If putting 10% of your monthly take-home pay toward a car would mean you could only save 12% of your income, instead, try to keep your car payment to no more than 7% of monthly take-home pay so you can put the recommended 15% minimum toward savings.

How long should your car loan term be?

While you need to know how much you can afford to spend each month on a car, focusing only on monthly payments is a problem. That's because many people end up stretching out the length of time they repay their car loan so their loan payments seem more affordable. The problem with this is, if you take a very long car loan, your monthly payment is lower but your total costs are higher, since you end up paying more interest over time.

Taking a long-term car loan also has another big downside besides higher interest cost: A long-term loan increases the chances you'll end up underwater or with negative equity. Negative equity means you owe more than your car is worth. If you take a long-term car loan and pay only a small amount each month, chances are good your car will depreciate or decline in value faster than you're paying it off. This can pose a big problem if you need to sell or trade in the car, because your car won't be worth as much as you owe on it. You'd need the cash to pay off the remaining loan balance, above and beyond what the car could sell for, or else you'd need to borrow this money to sell or trade in the car.

You don't want to end up underwater or paying a fortune in interest, so choose the shortest loan term you can afford. If you can afford to buy a reliable car by paying no more than 10% of your monthly income on a two-year car loan, you should do that. If you cannot afford to get a reasonably safe and reliable car with this short a loan, you may need to take out a loan with a longer term. But a good rule of thumb is to borrow for absolutely no more than four years. If you have to borrow for longer, scale down your expectations and shop for a lower-priced vehicle.

Taking out a shorter-term loan will also help you if you want to try to save up to pay for your next car in cash. if you've taken out a four-year loan but can drive your car for eight years, you could keep making payments to yourself during that four years you're driving your vehicle after your loan has been paid off. This should give you enough money to pay for your next car in full, or close to it.

How much of a down payment on a car should you make?

When you get a car loan, you'll usually be required to put at least some money down on the vehicle. Most reputable lenders want you to put at least 10% down. While you can find car loans that don't require any down payment, these tend to come with higher interest rates or other fees, or they may come from lenders you can't fully trust to treat you right.

Whether you're required to have a down payment or not, make the largest down payment you can afford -- and aim to put a minimum of 20% down on the vehicle. Making at least a 20% down payment is important so you reduce the chances of ending up underwater. As explained above, if you end up underwater, you have negative equity or owe more than the car is actually worth.

When you borrow for the full price of the car, the vehicle loses value immediately due to depreciation, so you're immediately underwater. In fact, if you buy a brand-new car, it will typically be worth about 20% less than you paid for it after a year. If you put anything less than 20% down, you're probably going to end up with negative equity.

This down payment should be cash you've saved -- don't put it on a credit card (unless you pay it back in full when the bill comes) or borrow it from another source. It can also come in the form of trading in your old vehicle, provided you owe less than the other car is worth.

Where should you get your car loan?

When you've got an idea of how much you want to borrow and have a down payment saved up, it's time to start shopping for a car loan. While many people just secure financing from the dealer, this isn't always the best approach. In fact, it's a good idea to shop for a loan before you go to the dealer so you can compare rates you get on your own with what the dealer offers.

You can shop for a car loan with online lenders, banks, and credit unions. Most lenders allow you to get a quote online by inputting some basic information, including the amount you want to borrow and details about your financial situation. Get several different quotes and bring them with you to the dealer. See if the dealer can beat the offers you get independently.

Some car loan lenders do a soft credit check to provide preapproval and give you an idea of the loan terms you'd be eligible for. Ideally, restrict your search to these lenders. Soft credit checks mean no inquiry goes on your credit report, while a hard credit check goes on your report when you actually apply for credit. Too many inquiries in too short a time hurts your credit score, and inquiries stay on your credit report for as long as two years.

While you will eventually need a hard credit check from whichever lender you get your loan through, there's no reason to get a bunch of inquiries when you're just shopping around and comparing rates.

What to look for in a car loan

When shopping around for a car loan, there are some key things to compare to make sure you're getting the best financing. You'll want to look at:

• Annual percentage rate (APR): This is the cost you'll pay to borrow, including interest and fees. A lower APR means the loan is more affordable.
• Fixed- or variable-rate loan: With a fixed-rate loan, your interest rate and payment remain the same for the entire time you have the loan. With a variable-rate loan, your interest rate is tied to a financial index and could go up or down. Variable-rate loans often start out at a lower rate than fixed-rate loans, but you lack certainty because your rate and payment could rise, and your loan could become more expensive. It's often best to choose a fixed-rate loan to make sure your payment is predictable.
• Loan term: Make sure the lender offers the loan term you're interested in. Remember, try to keep the repayment term to four years or less. And be sure when comparing loans that each has the same repayment term so you can do a fair comparison.
• Down payment requirements: You must be able to afford to make the down payment the lender requires.
• Qualifying requirements: Some lenders only lend to people with excellent credit, while others are more forgiving of past missteps. There's no sense applying for a loan you can't qualify for.
• Vehicle restrictions: Many auto loan lenders have restrictions on the age of the vehicle or the miles a used vehicle can have when you borrow to buy a car. And some lenders require you to purchase directly from a car dealer rather than buying from an individual seller.

Consider all of these factors so you can find a loan from a lender you're likely to get approved for, at a reasonable rate, to buy the vehicle you prefer.

Do you need gap insurance?

Gap insurance is an add-on to your auto insurance policy that pays the difference between what you get from your insurer and what's owed on your vehicle when something happens to your car.

Taking out a car loan always puts you at risk of ending up with negative equity -- although those risks can be minimized by choosing a loan with a short repayment timeline and making a big down payment. If you do end up underwater, you could have a big problem if your car is stolen or is involved in an accident and declared a total loss. If this happens, your auto insurance will usually pay the fair market value of the car -- which may not give you enough to pay off your auto loan.

Buying gap insurance ensures you have the money to actually pay off what you owe instead of owing money on a car you no longer have. Your lender may also require you to buy this insurance, but even if you're not required to, you should buy this coverage unless you have spare cash to repay your loan and don't mind getting stuck paying bills for a car that's been totaled.

What about your trade-in?

If you have a car to trade in, the value of the trade-in can reduce the amount you have to borrow or the amount you must pay for the vehicle on your card or with cash. The money you get for your trade-in could be used toward your car down payment, too, if you're borrowing.

But if you owe more than the trade-in is worth, you have a problem. You'll have to come up with the cash to pay off the existing loan or else increase your new car loan amount so you borrow enough to pay off the old loan and buy your new car. You don't want to do this, so avoid trading in a car until you've paid down the loan enough that you no longer owe more than the car is worth.

Also consider whether it makes sense to try to sell the car yourself rather than trading it in. You may get more money if you sell the car privately than if you trade it in with a dealer -- although this can be more hassle than many people want to deal with. If you do plan to trade in your car with the dealer, do your research in advance so you know what's a fair price and can negotiate with the dealer about your trade-in's value.

You should always negotiate the value of your trade-in separately before you start haggling on the price of a new car.

Planning for all costs when you pay for a car

When you're making plans to pay for a car, remember that there are additional costs to pay besides just the price of the vehicle. Some other costs you may incur include:

• Sales tax
• Car registration
• Document fees
• Title fees
• Emissions inspections
• Dealer fees

Fees can vary by state and depend where you buy your car. If you trade in a vehicle with the dealer, you can also get credit for the value of your trade-in so you won't pay sales tax on that amount. So if you buy a $30,000 car with a $10,000 trade-in, you'd be taxed only on $20,000 in value.

Ask the dealer for a complete breakdown of the costs you'll have to pay so you can make sure you have the money for a down payment as well as these up-front expenses.

Now you know how to pay for a car

Now you know your options for paying for a car: cash, credit card, or car loan. You also know how to find an affordable car loan and some pitfalls to watch out for to make sure you don't pay more for a car than you should. You can shop responsibly for your next new or used vehicle and make smart choices so buying a car doesn't cost more than necessary.