For many people, there’s nothing quite like taking delivery of your brand new car. However, taking on long-term loan to buy a car can have serious repercussions on your financial health.
We’ll take a look at the key issues and the ramifications of buying a car.
Question:
Hi, I’m Denise. Some people say the one single monthly commitment which can make or break your wealth building is payment of car loans. Is every car loan an upside-down loan as most cars depreciate much faster than we can settle them off, especially if we take a 7 or 9-year loan? In your opinion, how best to finance a car purchase? Is it in cash or a car loan?
First, what does Denise mean with “upside-down loan”?
If your car value depreciates faster than you pay off your loan, you will need to come up with extra money out of your pocket to repay the bank.
For example, when you sell your car at RM20,000, but your outstanding loan is higher, say RM25,000, you will need to fork out that difference of RM5,000.
In other words, it is negative equity.
That might happen in any of these situations:
- If you have a long tenure hire-purchase loan like nine years;
- You buy a car that depreciates too fast i.e. depreciates 50% in two years, versus some brands that only go down 50% after five years; and
- You finance the vehicle up to a maximum of 90%, 100% or even more after the mark-up price.
Or any combination of the above situations, you might end up with an upside-down loan.
Back to the question:
So, what is the best way to finance a car purchase? Should people only buy with cash, and only if they can afford to pay for the car in full?
To understand this issue, you must separate the subjects into two parts:
The Car And Its Value
Let’s get this straight. The value of a car falls over time. It doesn’t matter if you finance it with cash or with a car loan.
The higher price you pay for it, the more you lose. Whether you pay cash, or pay with a short three-year loan, or a long-term nine-year loan, or you only borrow 50%, regardless how you pay for the car, the car still goes down in value at the same rate.
It doesn’t matter.
The buyer of your used car won’t bother whether it the loan has been settled. They don’t pay you more because you don’t have a car loan. They might pay you more if the used car is well-maintained and looks good.
So, can we agree with these?
If you want to lose less money, just buy a cheaper car. Buy a better brand that depreciates less comparatively. Or the best choice, don’t get a car if you don’t need to. Buy the car that fits your needs now.
Don’t make the mistake I made. I used to own a 12-seater Hyundai Starex, and it was too big for my small family.
So, if you wish to be prudent about it, you may consider having a lower-priced car that serves your daily needs, or not get one for a car is a liability and its value depreciates in the long run.
How To Finance The Purchase
Now the second part is the one you want to consider – how to finance the purchase?
Short answer: That depends on the rate of return on your fund.
After you decide what specific brand, model and specification of vehicle you are going to get, the next step is to find out the cost of financing the purchase.
If you have 30,000 in a fixed deposit earning 2-3%, you might as well use that cash to pay for a car loan which will cost ~4%-5%.
On the other hand, if you have a stock holding that yields 8% a year, you should take a very long term car loan (nine years). So you keep your stocks… and earn the difference (8% stock yields – 5% car loan interest)
Does that make sense?
In summary, if you are a good investor, and you make an investment return that is way better than 4-5% you pay the bank, it is no-brainer to decide. Take the most extended loan that can offer the cheapest financing cost.
Debt Service Ratio (DSR)
So, let’s say you made that car purchase and your car loan installment amounts to RM 1,100 a month. If you earn RM 5,500 a month, the car loan installment is equivalent to 20% of your monthly income. This works out to be a DSR of 20%, that is if you have no other outstanding debt.
If you have other debt commitments such as a student loan (PTPTN), credit card debts, personal loans… etc, you may want to assess what your DSR is after you buy your car. For instance, if you are paying RM440 a month in PTPTN loan installments, you would increase your DSR from 8% to 28%.
Before buying your car
= (Existing loan commitment / Monthly income) x 100%
= (RM 440 / RM 5,500) x 100%
= 8%
After buying your car
= (Existing loan commitment + Car loan installment) / Monthly Income) x 100%
= (RM 440 + RM 1,100) / RM 5,500) x 100%
= 28%
So, What’s The Significance?
First, calculating your DSR will help you to determine if you can really afford the car purchase with a car loan. For instance, if you find that your DSR after buying the car is above 40%, you may want to reconsider because you could be over gearing. You could put yourself in financial distress if you lose your job, business or your sources of income.
Second, do you plan to buy yourself a home or an investment property some two to three years down the road?
Here is the thing. Little do people realise that the same RM1,100 monthly installment for a RM90,000 car loan is worth as much as RM220,000 in property mortgage.
Essentially, you are committing RM1,100 a month to get a RM90,000 car loan to buy a car that depreciates in value over time while forgoing your opportunity to acquire a property worth RM240,000 that could generate rental income and appreciates in value over time.
So, if you’re looking to buy a property in the near future, it would be helpful for you to refrain from getting a car loan and use your loan eligibility or quota for a piece of real estate.
The Final Piece Of Advice: Don’t Do The Following!
The above discussion is based on the assumption that you already have the money to buy the car. I strongly suggest that you put yourself in this position before considering to upgrade.
A car loan can only break your finances if you are spending your future money to buy it. That means you don’t have the money ready for the car.
So, you take up a loan to buy a car that is not affordable to you, perhaps to impress your colleague who just showed off his latest vehicle.
That’s a big NO-NO. Please refrain from doing that.
Don’t buy something you don’t need, with the money you don’t have, to impress the people you don’t like. That’s plain stupidity.
About the Author
This article is co-written by KC Lau and Ian Tai.
Ian Tai is a Dividend Investor. Financial Content Machine. Producer of 200+ Articles, Weekly Host and Presenter at KCLau.com. Co-Founded DividendVault.com, an online educational membership site that empowers retail investors to build a stock portfolio that pays rising dividends in Malaysia and Singapore.
KCLau is a financial educator, having published seven books including the current bestseller Money Smart, and co-created a dozen online financial courses. He gives away his popular Money Tips e-book volumes free at his website: https://KCLau.com
