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, let me explain what an upside down loan is. It is when the amount of your outstanding car loan exceeds the current market value of your car. For instance, your car is sellable for RM 50,000 but its outstanding loan is RM 60,000. Thus, if you sold off your car, you are required to fork out RM 10,000 to settle your loan amount outstanding to your financier.
This situation could happen if the car you purchased depreciates in value faster, let’s say 50% in two years, and you financed it with a car loan that amounts to a 90% or more of your vehicle’s price at a loan tenure of nine years.
So, is it better to buy your car with cash-in-full or with a car loan? In this article, I’ll offer three things you may consider to make a wiser decision in buying your next vehicle:
#1: The Value of a Car
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. So, if you wish to be prudent about it, you may consider having a lower-priced car that serves your daily needs or not to get a car altogether for a car is a liability and its value depreciates in the long run.
#2: Financing the Car Purchase
Let’s say, you have RM 100,000 and you wish to buy a car costing RM 100,000.
First, you can choose to pay it all in cash and thus, not getting yourself a loan to service. You save yourself an effective interest rate of 4-5% per year as you own your car debt-free. This is okay if your focus is to be free from debt. But, on the flip side, you will lose RM 100,000 in capital that you could use to build wealth.
Second, you may fund it with a 10% down payment and the balance 90% with a car loan that has a tenure of nine years. So, after you have placed RM 10,000 in down payment, you would have RM 90,000 in cash-in-hand, which enables you to easily service your car loan installment of RM 1,100 per month. Is this worth it? Well, it depends on how you choose to use the RM 90,000.
For instance, if you place the RM 90,000 into ASB that yields 6% a year, you will make RM 5,400 in interest income per year. If the effective interest rate of your car loan is 4% per year where your interest expense is RM 4,000 (RM 10,000 x 4%), you would make RM 1,400 in net interest income. Thus, you are paying for the interest portion of your car loan with interest earned from your ASB.
In other words, it makes more sense to finance your car purchase with a loan if you are a good investor who can achieve an investment return greater than the effective interest rate of your car loan.
#3: 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, thus, 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 PTPTN, credit card debts, personal loans… etc, you may want to assess what your DSR is after you bought your car. For instance, if you are paying RM 440 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%
After Buying Your Car
= ((Existing Loan Commitment + Car Loan Installment) / Monthly Income)) x 100%
= ((RM 440 + RM 1,100) / RM 5,500) x 100%
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 for you could be overgearing. 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 2- 3 years down the road? Here is the thing. Little do people realise that the same RM 1,100 a month in car loan installment that finances RM 90,000 in car loan is worth as much as RM 220,000 in property mortgage.
Essentially, you are committing RM 1,100 a month to get RM 90,000 in car loan to buy a car that depreciates in value indefinitely over time while forgoing your opportunity to acquire a property worth RM 240,000 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.
So, all in all, my views can be summarised as followed:
1. Your Purpose for Buying a Car
2. Your Skill Set as a Businessperson or an Investor.
3. Your Debt Service Ratio (DSR) after purchasing the car.
4. Are you planning to buy a property in the near future?
Here, I would like to hear from you.
Please do post a comment below and share with us how you intend to fund the purchase of your next car and your reasons behind it. Thanks!