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Conventional wisdom has long held that 20 percent is the magic number when it comes to buying a new car. But as it turns out, the vast majority of people are making far smaller down payments. An Edmunds analysis of new and used car purchases showed that the average car down payment in 2013 was about 12 percent.
That raises a few questions. Why are people making such low down payments? Is the 20-percent-down rule an outdated concept? And are there drawbacks to low down payments?
Why So Low?
"The main reason why people aren't putting enough down is because the cost of the vehicle has substantially increased, but people's income has remained relatively flat." says Jack Gillis, director of public affairs for the Consumer Federation of America.
The average down payment in 2005 was even lower than it is now: just 9.9 percent. Car shoppers have been making slightly higher down payments since then. But this is partly to offset the rising cost of a new car, which has gone up more than 10 percent in that time according to Edmunds.
Another explanation for the prevalence of minimal down payments is that interest rates on new cars are incredibly low, meaning there's little incentive for people to make larger down payments, says Jessica Caldwell, Edmunds senior director of industry analysis. (At one time, a big down payment was required to secure a low interest rate on a car loan.)
"Consumers are always trying to reduce their out-of-pocket expenses," Caldwell says.
In other words, many people want to put just enough down to get the payments and interest rate that fit their budget. Is that a solid strategy? It depends on your finance philosophy. But before we tackle that, let's look at what happens when a car buyer makes a low down payment.
The Depreciation Factor
"One of the problems in financing a car is that you are financing something of depreciating value," says Gillis. "The lender needs almost immediate protection: That's why 20 percent is typical."
Currently, new cars have an average depreciation of 20.5 percent after the first year of use, says Joe Spina, senior manager of remarketing for Edmunds.com. This falls into the general range of new-car depreciation of 20 to 25 percent, depending on brand cachet and the state of the used-car market. (You can calculate any car's initial depreciation by dividing the original purchase price into its trade-in price after one year of ownership.)
Take that depreciation, along with sales tax, finance costs and registration and pair them with a low down payment — or no down payment — and you get a buyer who is immediately "upside down" in the car purchase. In short, the buyer owes more than the car is worth.
By contrast, someone who makes a sizable down payment will have lower monthly payments, pay less in finance charges and immediately offset a new car's initial depreciation. To put it another way, the buyer will have equity in the car sooner.
Why Equity Matters
There are a few other reasons why equity is important:
If a car you buy is totaled in an accident or stolen toward the end of the first year of ownership, the insurance company would only pay the market value of the car — not what you still owe on your loan. If you put down 10 percent, you'd likely still owe the loan company money after you received that settlement check.
Once you paid that off, you would be back at square one: You would have no money to apply toward a down payment on another car. Some consumers would roll the remaining debt on the totaled car into a new car loan. And then they'd be even more upside down in that new vehicle.
Similarly, if you want to trade in your vehicle for a newer one in a few years, or if your financial situation changes and you have to get a cheaper car, having equity in the vehicle would allow you to sell it or trade it in without having to pay more money out of pocket.
Down Payment Philosophies
So what is the best down payment? Gillis says it's not a particular percentage or amount. It's just "the most you can afford." In other words, the more the better, but not so much that you don't have money for a household emergency fund.
Here are a few down payment philosophies. See which one speaks to you best and go with it:
Some people would prefer to put down as little as possible. Or perhaps they are having trouble saving up enough for anything but a minimal down payment. Most consumers have trouble saving, even for a rainy day fund, says Kukla.
The zero-down scenario keeps more money in your pockets. You can get into a new car without having to save for months in advance. Some of the drawbacks are higher monthly payments and higher finance charges. (This is not the case if you qualify for zero percent APR.) Plus, you will likely be upside down on the car loan — owing more money than the car is worth.
What about those "zero down and zero APR" specials that are often advertised?
Those are only available to a small minority of buyers says Gillis: a few as 10 percent of purchasers. And even if you are one of those people who do qualify, Gillis still recommends you make a down payment. This reduces the amount of debt you are taking on.
Somewhere in Between
This is perhaps where most people will end up. They want to make some type of down payment, but don't want to clear out their savings.
Take a look at your budget and see what percentage of the car's purchase price works best for you as a down payment. More is better. Use the Edmunds calculators to enter different down payment amounts and see how they affect the monthly payment. The general rule is that for every $1,000 that you put down, your monthly payment will drop by about $20.
Most You Can Afford
Though it may be difficult to save up for it, a large down payment, like 20 percent, does give you many benefits. If your budget can accommodate it, making a bigger down payment will allow you to choose a shorter finance term, which will save you money in interest charges. It will also cover most of the first-year depreciation and give you enough equity so that you would not have to come up with additional money if you were to decide to buy a different car. And if you had a theft or car-totaling accident, you would probably not owe anything on the vehicle.
Down Payments for Buyers With Subprime Credit
It is even more important to make a substantial new-car down payment if you have poor credit. Buyers with FICO scores of about 670 and below will have a hard time getting an auto loan from a bank or credit union unless they make at least a 15 percent down payment. The goal is to finance a smaller amount, so the more the buyer puts down, the greater the chances of being approved.
If you're one of those buyers, it's important to resist the allure of a longer-term loan with its more palatable payments.
"You're starting to see more people get into seven-year car loans, which reduce their monthly payment," says Kukla. But a concern is that people may get tired of their vehicles before they've paid them off, meaning "the loan may outlive the car." Rolling over payments to the next car is a bad start for a new loan.
Used-Car Down Payments
Things are a little different when it comes to used cars. Edmunds data shows that the average used-car down payment is about 11.5 percent. But that's not necessarily a bad thing in the used-car market. Like new cars, used cars depreciate, but at a much slower rate. For example, a five-year-old car purchased in June 2013 depreciated about 7.2 percent by the end of that year. Contrast that with a new car, which saw nearly 22 percent annual depreciation.
Used cars have an advantage in that the original owner "absorbed the initial depreciation," Gillis says. But he offers the same advice for used-car down payments as new ones: "Put down as much as possible."
Tips for Lower Car Down Payments
If you can't or don't want to make a 20 percent down payment, you do have some options to help keep you from being upside down in the car purchase:
- Make a bigger monthly payment. This will help you build equity in the vehicle, which is what you'd need in the event of a theft or an accident that totaled the car. It will also help you pay off the car sooner. Even adding $10 to $20 more per month can save hundreds in financing charges, says Gillis.
- Look for gap insurance or new-car reimbursement coverage. Gap insurance costs a few hundred dollars but can offset any difference between what you owe and what the insurance company gives you.
A number of insurance companies — including Farmers, Allstate and Amica — offer new-car reimbursement coverage. If your car is totaled or stolen within the first few years of ownership, the insurance company will pay the full cost of having it replaced. This coverage is usually sold separately or bundled in the higher-cost insurance packages, but it can be a viable option for consumers who put little money down and are worried about being upside down in their loan.
Keep Focused on the Long-Term Goal
In this era of monthly payments for things we don't own (Netflix and Spotify come to mind), it is easy to lose track of the goal of car buying, which is this: to own the car free and clear one day. Eliminating the second-largest debt you have in life is a great feeling. But how quickly you achieve that will depend on your finance philosophy.
If you can get past the impulse to buy a new car before your current one is paid off, you can avoid all the resale-value issues that a minimal new-car down payment can trigger. Once you've paid off your loan, you can do whatever you choose with your car. You can sell it, trade it in or just keep driving it. And you'll never have to worry about how bad it feels to be upside down.