Tuesday, July 23, 2024

Buying a car with cash? Here's how to determine when it's the best financial move for you

Edmunds presents the pros and the cons of paying cash for a car.

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A car buyer receives the car keys to his purchase.

Nattakorn_Maneerat // Shutterstock

Buying a car with cash is the ideal scenario for any vehicle purchase; it does not impact your credit, you don't have to worry about monthly payments, and it can save you money on finance charges you'd otherwise pay. Edmunds explains why this strategy isn't for everyone, as cars are expensive purchases, and not everyone can afford to do so. There are also tax implications for buying a car with cash to consider.

Some might think that paying cash for a car carries a lot of weight and the salesperson will be more likely to offer a better deal since it'll be apparent that you're a serious buyer with deep pockets. But oftentimes, the inverse is true. The dealership would prefer that you take out a loan since the dealer's securing it for you nets it extra profit on the deal. With this in mind, here are some factors you need to consider when deciding whether to buy a car with cash.

How to pay cash for a car

It is relatively simple to buy a car with cash, as it makes the process significantly easier. The only things you need to worry about are the selling price of the car and the "out-the-door" price with taxes and fees included. If you were financing the car, however, you'd also need to pay attention to the interest rate(also called APR), length of the loan, down payment and monthly payment.

You'll likely pay with a cashier's check, certified check, bank draft or a wire transfer. Some dealerships may not accept personal checks over a certain dollar figure, so call ahead to see what the dealer's policy is. If the cash transaction is over $10,000, you'll need to produce certain forms of identification and the dealership will need to fill out a form to report it to the IRS (more on this later).

Another way to effectively pay cash for a car is to go through the process of financing with the dealership, which often leads to a better price. Make sure to verify before you sign that there are no prepayment penalties for paying the loan off sooner. Then, in roughly seven to 10 days when the bank has secured the loan, call the bank to get a buyout price and arrange a wire transfer to pay off the loan in full. There may be a small portion of interest charges to pay, but it should be offset by the better selling price you arranged.

Tax implications of buying a car with cash

The main tax implication of buying a car with cash has less to do with filing your taxes and more about reporting to the Internal Revenue Service. Cash payments that exceed $10,000 (or multiple related transactions involving more than $10,000) for a car require that the dealership report the transaction to the U.S. Treasury's Financial Crimes Enforcement Network (FinCEN), by filling out a joint document with the IRS called FinCEN 8300. The dealership must record the customer's name, address, date of birth, taxpayer ID number and occupation. The buyer needs to present a form of identification, such as a driver's license or passport, and the ID number will be recorded at that time. This is a provision that dates back to the Patriot Act, which was aimed at curtailing "money laundering, tax evasion, drug dealing, terrorist financing, and other criminal activities." Note that the IRS has different meanings for "cash" depending on the quantity and the type of payment method used. A cashier's check with a face value of $12,000 does not need to be reported by the dealership, for example, because the bank would have already reported it on its end.

One way that buying a car with cash directly affects your tax returns is that you cannot deduct the portion of your interest expense used for business since you never took out a loan. According to the IRS, if you are self-employed and use the car you're financing for your business, you can deduct that part of the interest expense that represents your business use of the car. That said, it is still possible to take tax deductions for the sales tax, mileage, depreciation, and other ownership expenses on a vehicle you paid cash for. Check with your tax preparer to see which deductions you're eligible for and how to claim them properly.

Pros and cons of buying a car with cash

Pros:

No monthly payments: The best part about paying for a car with cash is that you never have to worry about monthly loan payments. You will have more of your income freed up every month to take care of more important expenses. The most popular loan terms today are for 72 months, which would tie you to monthly payments for six years.

No finance charges: While car loans make it possible for people to handle a vehicle purchase, the benefit is rarely free. Here's a rough calculation to illustrate this concept. For every interest rate percentage charged on a $40,000 vehicle with a 72-month loan, it would add about $1,300 to the total cost of the vehicle. The average interest rate at the time of publication was about 7%, which would translate to an extra $9,101 on the price of the $40K vehicle.

No concerns of negative equity: A common issue that happens with non-cash car buyers is that they don't make enough of a down payment to offset the first year's depreciation (roughly 20%). This leaves them in a negative equity or "underwater" situation, where they owe more on the car than it is actually worth. When you buy a car with cash, this isn't an issue since you don't owe any money after the purchase.

No credit check: Running a credit check is considered a hard inquiry on a person's credit. Having it done several times can lower your score, as the credit bureaus may think you're trying to overspend. In theory, there is no need for a credit check to be run when paying for a vehicle in cash. However, this can still happen if you're not careful. The U.S. Office of Foreign Asset Controls (OFAC) requires that car dealerships check customer names against a database of known dangerous organizations and individuals. This OFAC check tends to be incorporated into the dealership's loan processing system and often ends up being paired with a credit check. However, your Social Security number is not required to check the Specially Designated Nationals and Blocked Persons list, only your name and address.

If the finance person at the dealership tells you that the dealer needs to run your credit for identity verification, explain that you want to protect your credit from a hard inquiry and that you know a credit check isn't required for the OFAC. You can either ask the finance person to check the OFAC without a credit report or direct them to the government website. Your mileage may vary on this strategy, however, as some dealerships may have a credit check as their standard policy when dealing with a cash customer, as a potential backup in case the check bounces. It may be the dealership's policy, but it isn't the law. Other dealerships may be more flexible with the credit check and may instead offer to delay delivering the vehicle to you until the check has cleared the bank.

If you're paying with cash that requires IRS Form 8300, it does require your taxpayer ID or Social Security number, but a credit check is not required. In either scenario, make sure you communicate that you want to skip the credit check up front, and it's not a bad idea to freeze or lock your credit beforehand to prevent the dealer from doing so.

Cons:

You may not get the best price from the dealership: Here's a secret that many car shoppers may not know: A dealership does not make that much money on the sale of a car, particularly a new one. One of the ways a dealership compensates for that is by having arrangements with banks to get a small cut of the loans made on car sales. This means that it can afford to give the customer a discount on a car, knowing that it'll make some money on the back end of the deal. But when a person pays cash for a car, there is no such incentive for the dealership. It's not going to make money from financing and will be less likely to want to give a discount since it doesn't want to lose money on the deal.

May drain your emergency savings: While the promise of no car payments seems promising, if it comes at the expense of wiping out your emergency funds, it may not be worth it. It is always a good idea to have money stashed away in case of emergencies. A general rule of thumb is to have about three to six months' worth of your home expenses in your savings account. Once you have that safety buffer, it should be OK to proceed with buying a car with cash.

Will not be able to build credit: If you have relatively new credit or are trying to rebuild your credit from mistakes made in the past, paying cash for a car will not necessarily help in that regard. On the one hand, taking out a loan and making the payments on time will strengthen your credit, especially if you reach the end of the loan and pay it off. On the other hand, if you've struggled with making payments on time, it can be risky to commit to years of monthly payments

Is "never pay cash for a car" good advice?

There's a school of thought that says you should never pay cash for a car. It may seem counterintuitive, but let's explore it. The logic goes something like this: If the interest rate is low enough on the loan, you could invest the cash elsewhere and potentially earn a higher return than the interest you would pay on the car loan over the same period.

Let's say you're taking out a 72-month loan with zero down and a 2% APR on a $40,000 new vehicle. We'll keep the numbers simple here and not factor in sales tax since it varies widely. It would cost you about $2,500 in finance charges over the course of the loan. However, if you put that $40,000 in a high-interest savings account, with a 4% APR, you would gain roughly $10,600 over the same period. This would be a net gain of $8,100 by not paying cash for the car.

That sounds great on paper, but here's the reality of the situation. The average interest rate in the fourth quarter of 2023 was 7.4% for new vehicles and 11.6% for used vehicles, according to Edmunds data. You'd have a hard time finding an investment that would make that much back in return. Also, this strategy assumes that a person will not touch the money during that time because that would change the rate of return. Plus, few people can afford to not only put $40,000 in the bank but also maintain payments on a $40K vehicle at the same time.

This story was produced by Edmunds and reviewed and distributed by Stacker Media.