How Should I Finance My Car Purchase?
Some people think that the best way to borrow money to purchase a car is to apply for an increase on their home loan. The interest rate will likely be lower, so they assume that this will be the cheapest way to finance their purchase. But, is this really the case?
A motor vehicle is a fast depreciating asset. It is not uncommon for a $40,000 car to be worth around $15,000 after 5 years of ownership. After 10 years most vehicles are approaching the end of their economic life. So it is good practice to structure your finance so that you pay off your loan to purchase the vehicle in an equivalent time period.
Most mortgage loans have over 25 to 30-year terms. If you borrow against your home at say, 4%pa and make the minimum loan repayment, then after 5 years you will still owe more than $35,000 on the car. That is a net asset position of minus $20,000.
If you take out a car loan for the same amount over 5 years at say 7% per annum you will own the car outright after 5 years and pay much less interest! The two scenarios are summarised in the Table below.
| Car Loan | Home Loan | |
|---|---|---|
| Amount Borrowed | $40,000 | $40,000 |
| Loan Term | 5 years | 30 years |
| Interest Rate | 7% pa | 4% pa |
| Balance after 5 years | - | $36,388 |
| Repayment (per month) | $792 | $191 |
| Total Interest Paid | $7,523 | $28,478 |
Yes, the monthly repayments for the car loan are much higher. But consider what happens when you want to replace your car after perhaps 10 years? If you had taken the home loan option, you would still owe $32,000 on your clapped-out old car.
Then what about the option of borrowing against your home and paying the loan off over 5 years? That requires a lot of self-discipline and in my experience, rarely transpires, in spite of the best intentions. It is too easy to find excuses to spend your money on something else.
Go for the car loan - if you cannot afford the repayments, then perhaps you cannot afford the car!
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Loanscape has today released its Borrowing Capacity Index for Q4/2024. It confirms the forecast trend that borrowing capacities of Australian individuals and families are recovering from their low levels which coincided with the last of the recent increases to borrowing rates initiated by the Reserve Bank of Australia.