I recently wrote a post discussing whether it is best to get a new or used car. One astute commenter got me thinking about car loans, and zero percent financing in general. If you do it the right way, you can rule 0% financing to come out on top.
Commenter Baxter wrote: “Don't forget that if you have time to plan, you can sometime qualify for 0% finance. My truck payment comes out of an interest earning account (which has enough money in it to pay for the truck)”
While I did have a car loan in the past, many finance writers advocate that you should only buy a car that you can afford to pay for in cash. What if you can afford it, but you can get a 0% interest loan for five years? Should you still buy the car outright?
No. Definitely no.
If You Already Have the Money Saved
Let’s take a look at the numbers. Assume you have $15,000 saved up in a car fund and you are buying a car that costs $15,000. If you pay for it in cash, the $15,000 is out the door and you own the car. If you get the car for 0% interest with a 25% down payment, you spend $3,750 on day one. From there, you can keep the remaining $11,250 for five years.
What is $11,250 worth over five years? If you are responsible and keep it in a savings account, which you should, you can earn about 1% per year with a top savings account. With compounding interest, after five years that $11,250 becomes $11,826.55.
Saving the money, you get $576.55 in interest over the five years. That is not chump change. Even after taxes, you get to keep about $430.
This works with any zero percent interest offers. Whether you are shopping for a car or furniture, make sure to stash the money in savings to earn the interest you would have been giving away.
If You Don’t Have the Money Saved
If you don’t have the money already saved up, you should definitely be taking advantage of a 0% offer if you can. Why pay interest when you can borrow money for free? However, use the 0% to your advantage to create a “loan sinking fund” just as businesses have “bond sinking funds.”
To create your fund, start a new savings account with the goal of having the right amount of money to pay the entire loan off when the 0% period ends. We will stick with the car example from above for the numbers. Use a time value of money calculator to plug in your situation to find your specific savings amount.
If you know you will need to pay back $11,250 at the end of five years, work backward to find what you need to save every month to have that at the end. Without interest, you need to save $187.50 per month. With interest, you only have to save $182.78. I know it’s only $5 per month, but every dollar counts, right?
If you put away the entire $187.50 in the 1% savings account for five years, you pay off the loan plus you have a bonus amount saved up thanks to compounding interest. Your saved amount after the 60 months is $290.
The Power of Savings
Albert Einstein is famously (and likely incorrectly) quoted as saying that “The most powerful force in the universe is compound interest.”
Whoever did coin that quote was on to something. As you can see above, saving money with interest while borrowing without interest gives you a good opportunity to save real money.
Did I thoroughly confuse you? Do you have any questions? Have you tried anything like this before? Please share your questions, comments, and experiences in the comments.
Image by Joelk75