What's the best way to finance an automobile purchase? Your smartest alternative may be to pay cash. An all-cash purchase allows you to avoid the interest charges, fees, and monthly payments of an auto loan or lease. But, it also demands that you have more of your own money invested in the vehicle you purchase, with absolutely no financial leverage.

The choice of whether to use personal savings or the proceeds of a loan should depend, at least in part, on the rate of return that you're earning on your savings compared with the interest rate you'll be required to pay a lender. As a general rule, you should choose lender financing if you can earn a higher after-tax return on your savings than the bank will charge on a loan. However, if you're unlikely to earn a return that's comparable to the interest rate that you'll be charged on a car loan, you should use your savings to buy the new vehicle.

As an example, let's suppose that your savings are currently earning an annual return of 5 percent and you expect this rate to continue for the next several years. After paying taxes at a rate of 30 percent, you earn an after-tax return of 3.5 percent (the remaining 70 percent of the 5 percent annual return). So, if lenders are currently charging 7 to 8 percent interest on four-year automobile loans, then you're better off financing a car purchase by drawing on your savings rather than by taking out a loan. (This assumes, of course, that you've accumulated sufficient savings to pay for the car.)

One method for accumulating adequate savings is to regularly set aside a certain amount of money into a fund specifically designated for the purchase of a vehicle. The required contributions into the fund will depend on three factors: the return that you expect to earn on your savings, the length of time before you intend to make the purchase, and the amount of money that you need to accumulate. Therefore, the higher the price of the car, the sooner you want to buy, or the lower the return you expect to earn on your money, the greater the monthly contribution you'll need to make.

Setting aside adequate savings to pay cash for a car certainly sounds like a great idea, but in the real world it's much easier said than done. How can you go about saving money for your next car purchase when you're currently making payments on the car you're now driving? This, in effect, amounts to making double payments. Well, you might consider driving your present car an additional year or two after paying off the current loan. If you bought your current car two years ago with the proceeds of a three-year loan, then just bite the bullet and plan on keeping the car for three more years. During the two years following repayment of the current loan, continue to make the same payments into a savings fund for your next car purchase. Even though you may not be able to amass enough in two years to pay the entire cost of a new car, the savings will enable you to make a large down payment that would substantially reduce the loan payments required for the next car purchase. In fact, after one more cycle using this strategy, you should have sufficient savings to pay cash for the vehicle after that one.

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