What’s the Optimal Down Payment on a New Car?

In today’s world, purchasing a new car seems straightforward. Many rely on their trade-in vehicle to cover upfront costs, such as a down payment. However, the amount you put down on a new car plays a much more significant role than most realize. 

Between taxes and the slew of add-on products offered by dealerships, the amount you finance for a new vehicle could be substantially higher than the car is worth. Preventing this situation is not only critical for your finances, but it also protects your investment. 

We’re shedding light on the importance of your down payment and providing insight into how much you should put down on your next car.

Understanding Your Down Payment

A down payment is money you pay upfront to reduce the amount financed through a loan. The less that you finance, the less interest you’ll pay. There are three ways to reduce your loan amount:

Trade-In Vehicle: If you’re trading in a car, the equity in that vehicle can be used as a down payment. For example, if your trade-in is worth $10,000 and you owe $2,500 on your existing loan, you’d have $7,500 in equity. These funds could reduce your loan amount in the form of a down payment.

Cash Payment: Alternatively, you could pay money upfront to the dealership in the form of a cash payment to cover a portion of the vehicle price. 

Negotiations & Incentives: Dealerships are known for their promotions and price haggling. Any incentives earned or price reductions negotiated will lower your future loan amount.

People often use a combination of these three methods when buying a car. However, most are focused on how their down payment will reduce the monthly payments. They tend to overlook the role it plays in a key figure called loan-to-value.

What is a Loan-to-Value Ratio?

A loan-to-value ratio illustrates the value between the amount financed through a loan versus how much the car is worth. To calculate this figure, use the following formula:

Loan-to-Value Ratio = Loan Balance ÷ Current Vehicle Value x 100

Your loan balance is the amount currently financed. The vehicle’s appraised value is how much it’s currently worth (often estimated through services like Kelley Blue Book – www.kbb.com). Then, you’ll multiply the amount by 100 to generate a percentage.

For example, imagine you take out an auto loan for $47,500 and purchase a new car valued at $50,000.

Loan-to-Value Ratio: $47,500 ÷ $50,000 x 100 = 95%

Why Does Your Loan-to-Value Ratio Matter?

Your car loan’s loan-to-value ratio can potentially impact multiple aspects of your finances. 

Vehicle Equity: A loan-to-value ratio below 100% means you have equity in the car. Using the example above, you have $2,500 in equity or extra value in the vehicle. 

Depreciation: Vehicles lose value over time. Any equity you can generate early on will provide a buffer between the amount owed and the car’s worth.

Insurance Protection: If you owe more on your loan than the car is worth, it’s called being upside down or underwater on your loan. This situation can cause financial challenges if your vehicle is stolen or damaged beyond repair. 

For example, if you owe $50,000 on a car but it’s worth $43,000, your insurance provider will typically give you the cash value, or $43,000. You will be responsible for the $7,000 outstanding balance.

Discounts: Many lenders offer discounts or incentives if your loan-to-value ratio is below a certain threshold, such as 90%. This scenario lowers their risk level, and you benefit as a result.

Financing Options: Lenders generally have policies and requirements on how much they will finance on a specific loan. For example, some lenders may only finance loans below 100% loan-to-value. Others will opt for ratios over that with certain restrictions.

How Your Down Payment Impacts Your Loan-to-Value Ratio

Your loan-to-value ratio comes down to two things: The amount financed and the final cost of the car.

Many people overlook the extra expenses associated with purchasing a car. For example, you’ll have to pay taxes, title fees, and tag costs. Then, dealerships will attempt to sell you various add-on products, such as extended warranties. While some services, such as GAP (Guaranteed Asset Protection), are beneficial, they ultimately increase the final amount financed.

To illustrate, imagine you buy a car that costs $50,000. Once the taxes and add-on products are included, the final price is $55,000. Your loan-to-value ratio would be:

Loan-to-Value Ratio: $55,000 ÷ $50,000 x 100 = 110%

Down payments play a crucial role in protecting your investment and finances when purchasing a car. The true value of this figure is often overlooked. That’s why becoming pre-approved through the credit union is vital. 

Our team will review your finances with you and help determine how much you can afford to spend. Additionally, we’ll be able to guide you on how much you should put down to ensure your loan doesn’t become underwater.

If you want to learn more about auto loans or are ready to apply, we’re prepared to help. Please stop by any of our convenient branch locations or call 248-322-9800 extension 5 to speak with a team member today.

 

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