So, you’re set to buy a new or used car and plan to finance it, but the dealership has asked you for a down payment. For the uninitiated, a down payment is the lump sum of cash you give the dealership upfront for a new or used car to reduce the amount of money you’re financing.
Many lenders require down payments to show the buyer has a vested interest in keeping up with the monthly payments. It also proves to the lender the buyer can save the money needed to put down on the vehicle.
But one question often remains unanswered: How much money do you need for a car down payment?
How Much Money Do I Need for a Car Down Payment?
There are subjective and objective sides to this question. On the subjective side, you need just enough cash down to get approved for a monthly car payment that fits your budget. Objectively, the minimum down payment rule of thumb is 20% of a new car’s price or 10% of a used car’s price, according to Edmunds.
Always keep your minimum down payment in mind when car shopping. You may be able to afford the monthly payments on a premium vehicle with a lower down payment, but paying the recommended down payment percentage based on your purchase price protects your future finances.
Why Does My Down Payment Matter?
Putting 20% down on a new car or 10% down on a used car may seem high, but there are good reasons for it.
It Reduces Negative Equity
It’s no secret that cars generally depreciate, especially newer cars and luxury vehicles. For example, according to an analysis by Edmunds, the average new car depreciates a whopping 30.5% in its first year. After that, the depreciation tapers to 7.7% in the second year and 6.8% in the third.
With that rate of depreciation, if your new car had a $35,000 purchase price and depreciated at the average rate, it would be worth just $24,325 after a year.
If you bought the vehicle from a dealership, you likely paid additional fees, including sales tax, registration fees, documentation fees, and destination fees.
The fees you pay vary by regional and state laws. But if the sales tax is 7%, registration fees are $300, and documentation fees are $150, that’s an extra $2,900 on top of the vehicle manufacturer’s suggested retail price. You’re paying $37,900 for a vehicle that’ll be worth just $24,325 after one year.
If you put the national average down payment on this car, which is 11.7%, you’d finance $33,465. Suppose you finance this car for 60 months at a 4% annual percentage rate (APR). After one year, your loan balance would be $26,770.
That balance means you would owe $2,445 more than the car’s worth, which is known as negative equity, or being upside down, after the first year. It would take multiple years until the loan balance would be low enough to match the vehicle’s value.
But if you bump your down payment to 20%, you finance just $30,320. Using the same loan terms, that would put the loan balance at $24,254 after a year, meaning you’d have $71 in equity instead of negative equity.
If you moved to 30% down, you’d finance just a bit over $26,500. That would give you $3,127 in equity in a year using the same loan terms above.
Automotive equity matters for a couple of reasons:
- Insurance Concerns. If the vehicle is damaged beyond repair or stolen and never recovered, your insurance only covers its value. So if the car is worth $24,325 but you owe $30,000 on it, you must pay the remaining $5,675. The only exception is if you have gap insurance to cover the remaining loan balance.
- Trade-In Concerns. If you trade the vehicle in after a year or two, you have to pay more for your new car because the dealership must include paying off your old car’s negative equity with the new loan.
- Refinancing. With automotive equity, it may be easier to refinance the vehicle for a better rate later.
- Collateral on a Loan. You can also tap into the automotive equity by taking out a personal loan using the equity in the vehicle as your collateral. But note that if you default on this loan, the lender can repossess your car.
It Lowers Your Monthly Payment
The larger your down payment, the lower your loan will be, which decreases your monthly payment. A general rule of thumb is for every $1,000 you put down, your monthly payment decreases by $15 to $18, according to Edmunds.
If you’re working with a tight monthly budget, that extra cash in your pocket each month can keep the bills paid.
It May Lower Your Interest Rate
When financing a car, a high down payment shows the lender you’re confident you can pay off the vehicle if you’re willing to sink that much money into it upfront. In turn, the lender may view you as a lower risk and offer you a better interest rate.
With a lower interest rate, you get lower monthly payments and pay less interest over the life of the loan.
For example, a five-year $30,000 loan at a 4.99% interest rate costs $566 per month, and you’ll pay $3,959.97 in interest over the loan’s life.
If you put an extra $2,000 down and dropped the interest rate to 4.5%, you’d pay $522 per month and $3,320.27 in total interest over the loan term.
It May Help Get You Approved
You may not get the greatest loan terms, but you can always refinance into a better loan after building your credit with on-time payments. Plus, with that larger down payment keeping the depreciation minimized, it’s easier to refinance the vehicle a few years down the road.
How Can I Lower the Down Payment I Need?
Don’t give up if you can’t afford a large down payment to hit that 10% or 20% mark on your dream car. There’s a handful of options to help you reduce your down payment amount and still get a new or used vehicle.
Bring a Trade
If you have a vehicle that’s in good shape, you can trade it in at the dealership for credit toward your new or used car. The dealer accounts for this the same way it would a down payment, but no cash comes out of your pocket.
Aim to maximize the trade-in value by cleaning the vehicle before taking it to the dealership and ensuring it’s in suitable running condition.
Also, research its retail value (the price a dealership can sell it for) and wholesale value (the price a dealership should buy it for) and have this information prepared for the negotiation process. Dealers typically offer you the lowest price possible for your trade-in, but you can counter their offers and back up your counter with facts and data.
You can get approximate trade-in values at Kelley Blue Book or NADA Guides (a service provided by the National Automobile Dealers Associated and J.D. Power). Both sites also offer fair selling prices at dealerships, allowing you to complete all your research in one place.
If your trade-in car has a loan, call the lender to get a payoff balance and compare it to the wholesale value. If the payoff is higher than the wholesale value, you’re upside-down.
Being upside-down on your trade-in vehicle negatively impacts your down payment, meaning you must make a larger down payment.
Search for Cash Incentives
Automakers always look to attract more customers, and some do so through special cash incentives. It’s sometimes called customer cash, holiday cash, or finance bonus cash. Whatever name the automaker gives it, the lender treats these cash incentives as down payments.
You can apply these incentives to your current down payment, lowering the amount of cash you must pay out of pocket.
Be aware of any exceptions these incentives include. For example, automakers typically won’t offer these cash incentives along with a special interest rate. In some cases, these offers are only available on certain trim levels or in-stock vehicles and may require financing through the automaker’s captive financing arm, such as Toyota Motor Finance.
Switch to a Lease
Sometimes, leasing a new car is a suitable alternative to buying. In a lease, you only pay for the amount of the vehicle you use and a small monthly money factor fee, the leasing equivalent of an interest rate. Plus, the upfront costs are often lower.
Another lease benefit is the option to buy the vehicle at the end of the lease term for its residual value, which is the vehicle’s retail value at the time of purchase. And you can finance it like you would any other used car.
The dealer notifies you about the vehicle’s end-of-lease residual value at signing, so you know upfront exactly how much you’ll have to pay to buy it. That allows you to save extra cash for a down payment to finance the vehicle at lease end.
Because buying your car at lease end is the same as buying a used car, you can come down to the recommended 10% used-car down payment. Plus, you get to test the vehicle for a few years before buying it to ensure it’s the right car for you.
There can be some negative trade-offs to leasing, though. First, depending on the money factor you get, you could end up paying more for the vehicle during the lease than if you financed it. To determine whether that’s the case, multiply the money factor by 2,400 to convert it to an APR and compare the result to the interest rate if you financed the vehicle.
For example, if the money factor is 0.0025, it would convert to 6% APR. If you could finance the vehicle for less than 6% APR, the lease would cost you more than financing.
Another downside is that the dealer calculates the residual value at the beginning of the lease. Sometimes, the vehicle’s actual value is lower at lease end, but you still have to finance the residual value to buy the vehicle at that time. In this case, you would overpay to finance the car.
Choose a Less Expensive Car
Another way to immediately lower the down payment you need is to choose a car that costs less money. You can pull this off several ways.
- Downsize to a Smaller Car. If you’re looking at a fully loaded 2018 model-year midsize sedan, you could scale down to an equally well-equipped 2018 compact or subcompact car.
- Opt for an Older Car. If that midsize 2018 sedan has been essentially the same car since 2016, you may be able to find a better deal on a 2016 or 2017 version of the same vehicle.
- Choose a Lesser-Equipped Car. If you’re looking at the fully loaded midsize sedan that runs $40,000, the entry-level version of that same vehicle may be less than $30,000, which can help reduce the recommended down payment amount.
Opt for Gap Insurance
The biggest risk you run by being upside-down on your car loan is if an insurance company deems the vehicle a total loss after an accident or theft. In that case, the insurance company says it’ll cost more to fix the car than it’s worth, so it agrees to pay you the car’s total value.
But if you’re upside-down on the loan, the amount the insurance company gives you won’t pay off the loan. Gap insurance covers that difference.
After buying gap insurance, your only concern is how depreciation will impact you if you resell or trade in the vehicle. To help absorb some depreciation, make a down payment of at least 10% on a new car and 5% on a used car when buying gap insurance.
For example, if you purchase a $30,000 new vehicle, aim for $3,000 down plus gap insurance. If you purchase a $20,000 used vehicle, put at least $1,000 down plus gap insurance.
You can purchase gap insurance from several sources:
- Through the Dealership. Some dealerships offer gap insurance as an add-on that tacks $400 to $600 onto the financing contract, according to Edmunds.
- Through a Credit Union or Insurer. If you’re financing through a credit union or buying from a stand-alone gap insurance provider, they may also offer it for around $200, according to Edmunds.
- Through Your Existing Car Insurance Company. You can also contact your insurance company about their gap options. Generally, your car insurance company will charge you a higher premium as opposed to a one-time fee.
If you add gap insurance as a part of your financing contract, your monthly loan payments will increase slightly.
How Can I Increase My Down Payment Savings?
If you can wait on buying that dream car, you can increase your down payment savings with a few tips.
Sell Your Trade-In Vehicle
When a dealership offers to take a vehicle as a trade, its offer is often less than you can sell it for on the open market. Sometimes, it’s significantly lower.
On top of the decreased value of the car as a trade, the dealership must also consider reconditioning costs, which can further reduce the offer.
If you can delay purchasing your next car until the right buyer buys your old vehicle, you can add some extra cash to your pocket by selling the car yourself.
For example, if the dealership offers you $5,000 for your trade-in vehicle but its private-sale value is $7,500, you have the potential to add $2,500 to your down payment by selling it yourself.
You can find private-party values at a car valuation site like Kelley Blue Book to see how the private-party and trade-in values differ.
Get a Side Gig
You can also take a skill you have, like Web development or writing, into the freelance space and earn cash in your spare time. The side-gig options are virtually endless.
The best thing about side gigs is once you’ve earned the cash you need to meet your needs, you can freely choose whether to continue earning extra cash or leave the side gig.
Temporarily Cut Expenses
A slightly more dramatic option is to cut expenses temporarily while you save toward your down payment. Review your budget and see what discretionary expenses you can trim, such as dining out, subscription services, streaming services, and commuting expenses.
You can also reduce monthly bills like cable or Internet by negotiating with your service providers. Bill-negotiation services like Trim and Billcutterz can negotiate these bills for you, saving you the stress of doing it yourself.
Funnel the cash you’d typically allot to those expenses into a high-yield savings account for your down payment.
This option may significantly delay your car purchase as you save, but it’s a fiscally responsible way to save for a down payment without taking on a side gig.
Pro tip: One of our favorite savings accounts right now is with Axos Bank. They have a competitive APY and great customer service.
Take Out a 401(k) Loan
It’s usually not wise to take any loans as down payments for other loans. It increases your monthly debt payments and debt-to-income ratio to a point where the auto lender may decline your application.
But a 401(k) loan is a different breed, as you’re borrowing from yourself, not a bank. There’s no credit check, and the loan never shows on your credit history. Plus, the interest you pay on a 401(k) loan goes into your 401(k) account, not to the financial institution. So you’re paying yourself interest.
Most 401(k) providers allow you to take up to 50% of your vested 401(k) balance as a loan, up to $50,000.
But there are downsides to a 401(k) loan.
- Fees May Apply. You may pay a loan fee to the 401(k) provider.
- Another Monthly Payment. You must commit to making monthly payments to replenish your 401(k) within five years.
- Missed Growth. You miss out on the potential growth of the money you borrowed until you repay it in full.
- Possible Taxes and Penalties. If you leave the employer who sponsors the 401(k) you borrowed from, the loan terms may require an accelerated repayment. If you can’t repay it in time and are under 59.5 years old, you’ll pay income taxes and a 10% penalty on the total amount remaining on the loan.
Because of the potential impact on your future retirement savings, a 401(k) loan should be a last resort measure. If your current vehicle is still in good shape and you simply want a new car, a 401(k) loan isn’t a path you should take.
However, if you legitimately need a new vehicle and a 401(k) loan is your only option, use it responsibly by only taking the money you need and keeping the new vehicle price as low as possible.
Getting a new vehicle can be exciting, but don’t let the thrill — or the pushiness of a salesperson — lead you into a poor financial decision, like putting too little money down on the car. By keeping your down payment within the recommended ranges, you’re mitigating several potentially damaging financial situations.
By keeping your down payment high, you absorb a portion of the massive first-year depreciation on a new car. That can help with reselling or trading it in the future. Plus, it prevents you from owing money on a totaled vehicle you can’t drive.
So before heading to the car dealership, research the prices of the cars you like and estimate your recommended down payment to ensure you have the cash you need.