0% Financing is a lie

Did you know the average Canadian is willing to pay 20% of their monthly take home salary to finance a car? That’s a lot, considering that the average mortgage shouldn’t be more than 30% of your monthly take home salary.

Let me put this another way: if you are paying 30% of your take home salary to own a home, would you be willing to pay 20% of your take home salary to own a car? Or, if your goal is to own a home, do you really want to be financing a car before you finance a house?

I’m in the no camp, but then again, I’m also the one who believes that self driving Uber like services will happen within a decade (people have told me that the technology is already in place in Tesla!). But your life circumstances might be different. So let’s assume that you are intent on owning a vehicle. You’ve also seen those ads touting that you can have a brand new ride at 0% financing.

Have you ever wondered why or how these companies are willing to do 0% financing? I have. Not because I plan on buying one, but because I’m interested in understanding how they can make ends meet by offering it.

And what I found surprised me.

But before we get into that, let’s make sure we’re on the same page.

What does financing a car mean

Think of financing a car like a mortgage on a house. You borrow money from an institution to buy the car, just like you would borrow money from an institution to buy a house (what’s typically called getting a mortgage on a house). That way, the car is yours, so long as you continue to make the monthly payments.

In order to finance the car, the most common options are through the car dealership themselves, through a bank or through a credit union.

Typically, car dealerships will offer the highest cost for financing (highest interest rate, meaning you’ll pay the most). The only time that this wouldn’t be the case is if the dealer has a special financing rate (ie the 0%).

Just like a mortgage, the banks will also offer you financing, but they will typically still be higher than what you could get elsewhere. There are many reasons why this is the case, but my hunch is simply because they can as that’s where most people will go since it’s a place they’re familiar with. And people are lazy.

A cheaper place might be your local credit unions. Since their goals and objectives aren’t to make the most money off their clients, as their clients are also the owners of the credit union (as opposed to with banks, where the owners are shareholders), they will typically be able to offer you a better rate.

But it’s not as simple as choosing the source of financing.

Credit score required to finance a car

Another thing to consider if you are going to finance a car is your credit score. It is said that the average person who finances a new car has a credit score of 714.

That doesn’t mean that you need to have a credit score of 714. But just because you can qualify for one with a lower credit score doesn’t mean you should do it as your interest rates on these loans skyrocket.

Let’s be clear, you will only qualify for 0% financing if you are in the super prime category.

If you’re not there, read our ultimate guide to credit scores to find out how to improve your score.

And if you do qualify for the 0%, should you take that offer?

It depends. First, let’s talk about why…

0% Financing is a lie

There are a few ways that car companies make money:

  1. Through the sale of each car
  2. Through getting you to purchase upgrades
  3. Through financing activities

So long as these ways add up to being more than the cost of selling the car (plus some minimum profit requirements), they will be glad to make the sale every time.

So if they’re willing to give you 0% financing, they must make money off you buying the car with some upgrades.

That’s fair.

But here’s the problem.

When you were to buy the car for cash, what typically happens when you’re talking to dealer, particularly with bullet 1, even without any real negotiating?

Yep, you qualify for cash discounts, manufacturer’s discount, dealer discounts.

And these discounts can add up to being a pretty good percentage of the total cost of the vehicle.

However, when you try to get those same discounts with the 0% financing, what happens?

You get rejected. They’ll say something along the lines of you’re already taking advantage of one of our promos and the promo does not allow you to take advantage of their other promos.

So what exactly does this all mean?

It means that you’re essentially trading 0% financing for all the cash discounts.

If I’ve lost you, let’s look at this from another angle.

If you paid in cash, you can get the vehicle for $29,665.48 after all tax and fees.

If you decided to go down the 0% financing for 4 years route, the vehicle will cost you $31,665.60.

So the 0% financing actually costs you $2000 ($31,665 – $29,665 = $2000).

And yes, this is a real example of the 2017 Toyota Camery LE Upgraded.

How can this happen? It’s because they inflate the vehicle price and then promote the 0% financing on this higher price. And if someone was willing to come in with cash, they would use “cash discounts” to bring the price back down to what they actually wanted to sell the car for.

So is 0% financing really 0% or free if you’re paying $2000 to have that option?

I know. I still haven’t actually answered if the 0% financing is worth it. It’s because the answer is still it depends.

Is it better to buy or finance a car

You would think that this answer is pretty straight forward, given what we’ve covered so far. But it isn’t. In order to know if you are better off buying the car or financing it, we need one crucial piece of information: how much does it actually cost you to finance a vehicle?

Going back to the example with Toyota, we’ve shown that the cost of what they call “0% financing” actually costs us $2000. So what we need to do is figure out what interest rate gets our cash purchase of $29,665.48 to $31,665.60 in 4 years time.

The easiest way to do this is to turn to the internet and its infinite ability to find us the website we need. What I did was use an online payment calculator. I stuck in $29,665.48 as the purchase price, changed loan term to 4 years, put 0% for sales tax (since it’s already in the purchase price), and kept guessing interest rates until the total payment was close to $31,665.60.

Using this method, I got the interest rate to be 3.24%. Isn’t that something? They advertise 0% but it actually costs you 3.24%.

Now that we know the true cost of financing, let’s answer the question of whether it’s better to buy or finance a car.

By the way, we’re still at a it depends stage. The short answer to this is if your money is able to do better than the true cost of financing (in this case, 3.24% each year), you are better off financing the vehicle and paying the 3.24%. However, if your money is not giving you more than the true cost of financing, you are better off buying the vehicle in cash.

Kind of lost? It’s okay, we’ll cover all the scenarios you’ll need to know.

The long answer goes into a very important concept called opportunity cost. What opportunity cost says is that you are always choosing between things. If you choose one thing, you are forgoing the ability to choose the other. The most simple example of this is using time. You can choose to spend your time watching Netflix. But if you do end up watching Netflix, you can’t simultaneously be out with your friends.

This is the same with money. Your money can only be doing one thing for you. It can be making you money (high interest savings account, GICs, dividends, etc), or it can buy you something. The opportunity cost of buying something is that the money cannot be making you money anymore.

In order to decide whether it’s better to buy (and give up the ability for that money to make you more money), or to finance (you borrow other people’s money and pay interest, but keep the ability for your money to continue to make you more money), the question comes down to what other opportunities is your money able to partake in?

If your money is going to sit in your bank account and earn you 0%, you are better off putting your money into buying the car for cash and saving 3.24%. You should also consider a bank account that will pay you more than 0%.

If your money is in a high interest savings account, you will have to look at whether the interest you are making is higher than the true cost of financing. As for June 2017, the interest rate for the highest high interest savings account is 2.3%, so for the purposes of our example, 2.3% is less than 3.24% which means you should take out the money and pay for the vehicle in cash.

The same idea applies for GICs (you are probably better buying the car for cash instead of putting the money into a 4 year GIC).

What gets interesting is when we start looking at dividends.

As of the very day of writing, if you were to buy stocks of TD Bank, the dividend rate is 3.66%. That means you can expect to make about 3.66% of your money invested in TD each year.

So if we had the option of investing in TD and making 3.66% or using that money to pay cash for the car, and save 3.24%, investing would be a better option, and we would come out ahead doing so.

Of course, this is a very simple example. There is a lot more to think about when investing in stocks as the price for the stock will fluctuate.

And now, the most interesting idea of them all.

We know that if our option for our money is less than our true cost of financing, we’re better off paying the vehicle in cash. But if our option gives us a better return than our true cost of financing, we’re better off financing the vehicle and putting the money into our better option.

But here’s an idea: what if we can find an alternative loan that will cost us less than the true cost of financing, take out that loan and use that money to pay in cash?

Here’s an example. Let’s say you still have a line of credit that gives you interest rates at prime (2.70%). You can take out a part of your line of credit and use that money to buy your vehicle in cash. Now, instead of paying the original true cost of financing (3.24%), you have taken a loan at a lower rate (2.70%), saving you the difference in interest payments (0.54%).

Once again, the example is meant to illustrate the idea of understanding your opportunities with your money. The big thing you have to be careful of with the using a line of credit example, is that the line of credit can have its interest rate changed which means you could be worse off before you pay off the loan.

Conclusion

We know that financing is similar to taking out a mortgage for a house: you are expected to pay back the loan over the course of a set amount of time.

We looked at the most common sources of financing.

We also know that credit scores play a vital role in not only whether you are qualified for financing, but how much you will pay in interest.

We’ve shown that 0% financing is a lie, and that you are actually paying quite a bit for what they call 0% financing.

We’ve explored the whole finance vs buy question, and have shown that it really boils down to your alternative options for your money (or opportunity cost).

Knowing what you now know, what advice do you have for your family and friends? What advice do you have for your fellow readers?

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