Pros and cons of financing a car: Should you pay cash instead?

While prices are dropping, new vehicles still come at a high cost, averaging $47,401 in January. Financing a car might be your easiest route to get behind the wheel. Many buyers do: Auto loan balances increased by $12 billion in the fourth quarter of 2023, according to the New York Fed.

But is financing a car a good idea? Loans of any sort come with risks. You may be able to afford a better vehicle, but a loan can leave you at risk of damaging your finances. Before comparing auto loan rates, take some time to understand whether financing a car is a good idea.

Pros and cons of financing a car: Quick look 

Pros of taking out an auto loan:

• Spreads out the expense over years.
• Can help afford a better car.
• You’ll own the car after you pay off the loan.
• Can help improve your credit score.

Cons of taking out an auto loan

• Monthly payments might be expensive.
• There’s a risk of damaging your finances.
• The vehicle’s value depreciates while you’re still paying.
• You’ll be stuck with the same car for longer.

Benefits of taking out an auto loan

Should you finance a car? Securing an auto loan comes with perks that other ways of getting a car do not.

Spreads out the expense

Few drivers can purchase a car with cash. An auto loan reduces the amount you spend upfront. It swaps a big one-time expense for a smaller ongoing one.

It also leaves you with money in the bank to use for other purposes. Draining your savings leaves you without an emergency fund, which could come back to bite you in the future.

Afford a better car

Financing a car might mean a higher-end option fits your budget. Determine how much car you can afford to finance. Generally, this number will look much better than you could pay in cash.

You own the car at the end

Many consider leasing versus buying when looking into new vehicles. While leasing can put you behind the wheel at a lower monthly cost, you should consider the end-game difference.

Getting an auto loan leaves you with a vehicle you own. Leasing does not (unless you choose to buy out your lease). Once you pay off the loan, you can use it for as long as you’d like and eventually sell it to recoup some of your costs.

May improve your credit score

Your payment history makes up 35 percent of your FICO score. If you can keep up each month, your credit score should increase over the loan’s term.

Your credit mix — the different types of credit you have — also plays a small role in your credit score. Adding an auto loan can diversify your credit mix and slightly boost your score.

Disadvantages of taking out an auto loan

Getting an auto loan is one of the most effective ways to afford a car, but it has downsides.

Monthly payments can be expensive

Even if you finance a vehicle that fits your budget, your monthly payment can be steep. On average, drivers pay $738 per month for new vehicles, according to Experian. And this high cost is on top of insurance, which averages $2,545 annually, according to Bankrate data.

Risk of damaging your finances

Falling behind on your auto loan payments will lead to trouble. Even one missed payment will hurt your credit score. And multiple missed payments can lead to your vehicle being repossessed.

This is because, for most auto loans, your vehicle secures the loan. If you cannot make payments, the lender technically owns it — and will repossess it to recoup its losses. But even if you chose an unsecured auto loan, you could be taken to court for missed payments.

Your vehicle’s value depreciates

Your vehicle will depreciate the moment you drive off the lot. A car may lose 20 percent of its value in the first year. If you have a high interest rate, you could owe more than your car is worth — what’s called being upside-down on your loan.

Being upside-down on a car loan is a bad situation. It means that you can’t sell the car unless you have enough savings to make up the difference. It could also cause problems if you get into an accident and total the car. If you don’t have a policy that pays off the full amount of your loan, your insurance payment likely won’t be enough.

Stuck with the same car for longer

Unlike with leasing, the vehicle you sign off on is the vehicle you will be operating for the foreseeable future. These days, long loans are the norm, with the average auto loan for a new car lasting 68.26 months, according to Experian.

If you opt for a long loan term, you could be stuck with the same car for longer than you might want. This is especially true if you imagine yourself changing your mind, as selling a car with a lien can be complicated.

Should I finance a car?

After you compare the pros and cons of auto loans, answer some questions about your finances and your needs for the vehicle.

• What can I afford? Unless you can afford your dream car upfront, an auto loan is the most effective way to get a vehicle. Use an auto loan calculator to estimate your expected monthly cost and ensure you can afford it.
• Do I need to build my credit? Signing off on a loan you know you can pay off can be a great way to watch your credit score grow.
• How long do I want this vehicle? Auto loans tend to last between 36 and 84 months. At the end of your loan term, the vehicle is yours. So if you intend to swap cars frequently, leasing may be a better option.

Auto loan alternatives

Signing off on an auto loan may be the most obvious way to get a vehicle, but it is not the only way. Consider whether an alternative to traditional vehicle financing is better for you.

• Leasing a car. Although leasing a car has restrictions that buying does not, it costs less each month. This option is best if you want a luxury vehicle or to change vehicles regularly.
• Buying with your savings. Dipping into your savings account can help you to afford a vehicle or put more toward the down payment, lowering your total cost. If you choose this route, be sure you still have enough to cover an emergency fund.
• Using a credit card. Before showing up in the dealer’s office with a card in hand, you must check if it is allowed by your creditor. It is also important to pay attention to your credit utilization rate to be sure you don’t damage your credit score.
• Tapping into your 401(k). Using your retirement fund can be risky and might even delay your retirement. But if you have a stable job and can stay within your budget, it could be an effective move.
• Using a personal loan to buy a car. Just as you can use a personal loan to cover unexpected expenses, you can use a personal loan for a car purchase. If you take this route, prepare for higher rates and shorter terms since most personal loans are unsecured. For example, LightStream is an online personal lender offering auto loans.

The bottom line

Should you finance a car? Deciding if an auto loan is right for you depends on your financial state and how long you want the vehicle. And if vehicle financing is right for you, do your homework by learning how to get the best auto loan rate.