Should I buy a car with cash?

Hand holding cash for car keys
In order for borrowers to determine whether buying a vehicle with cash is right for them, they need to consider the lost opportunity cost that will occur as a result of avoiding a car loan.

Lost opportunity cost, sometimes referred to as the LOC, is the potential future growth on a sum of money that is lost as a result of that sum of money being used for a purchase. In terms of vehicle financing, the lost opportunity cost occurs as a result of money being diverted to the purchase of a vehicle instead of to a car loan.

For instance, imagine a borrower who has $20,000 in an investment account that has an annual return of 5 percent. Every year, this borrower is making $1,000 on interest alone. Now, if this borrower decides to withdraw his $20,000 and put it towards the purchase of a vehicle, he will lose that interest payment, thus incurring a lost opportunity cost of $1,000 a year.

If it takes the borrower five years to replenish his investment account, then the lost opportunity cost will equate to $5,000 ($1,000 multiplied five times over).

On the other hand, if the borrower keeps his money invested and instead secures a car loan, then his lost opportunity cost has the potential to be significantly less. The lost opportunity cost incurred as a result of financing a vehicle with a car loan comes in the form of fees and interest payments.

Assuming the borrower could land an interest rate of 7 percent on a five-year $20,000 car loan, it will cost him roughly $3,760 in interest. If the lender charged him $150 to originate the loan, then the total lost opportunity cost for financing a vehicle with a car loan would equate to $3,990.

By keeping money in the investment account and financing the vehicle instead, our borrower would save $1,010 in the form of lost opportunity cost ($5,000 versus $3,790). In this particular circumstance, passing on paying cash and instead opting to finance the vehicle is a more financially prudent move.