How Much Should a Car Down Payment Be?

Conventional wisdom has long held that car purchasers should plan on a 20 percent down payment for a new car. But a recent Edmunds analysis of new and used car purchases shows that the average car down payment in 2011 was about 11 percent. This raises a few questions. Why are consumers making such low down payments? What is the right amount of money for a down payment? And what are the drawbacks of a low down payment?

The Trouble With Low Down Payments on a New Car
One explanation for the popularity of minimal down payments is that interest rates on new cars are incredibly low, meaning there's little incentive for people to make a larger down payment, says Ivan Drury, Edmunds manager of pricing and industry analysis. "They'd rather hold on to whatever cash they have on hand," Drury says.

In other words, many people just want to pay the bare minimum down in order to get the payments and interest rate to a point that fits their budget. But this approach ignores an important factor: depreciation.

Having a low down payment — or no down payment — instantly puts a buyer "upside down" in his car purchase. Thanks to car depreciation, which begins the minute a new car leaves the dealership, the buyer owes more than the car is worth.

There are numerous factors that can change the rate of depreciation, such as brand cachet and the state of the used-car market. But the general range is between 20 and 25 percent. Currently, new cars have an average depreciation of 21.8 percent after the first year of use, says Joe Spina, senior manager of remarketing for Edmunds.com. (You can calculate any car's initial depreciation by dividing the original purchase price into its trade-in price after one year of ownership.)

In contrast to the low-down or no-down buyer, someone who makes a sizable down payment will have lower monthly payments and offset a new car's initial depreciation. To put it another way, he'll have equity in the car sooner.

The Explorer Example
To show the effects of varying down payments, we're going to use as an example a car that sells for what the typical automobile sold for in 2011: $29,505, according to Edmunds analysis. We chose a 2012 Ford Explorer, which in its base model matches that amount. An 11 percent down payment for that car amounts to $3,263.

No Down Payment/Low Down Payment
Let's say that for some reason, we hadn't saved up for a down payment. Or let's say that Ford had a "zero due at signing" special on the Explorer. If we don't put any money down, we will automatically be upside down with our purchase as soon as we make it.

If our Explorer were totaled in an accident or stolen toward the end of the first year of ownership, the insurance company would pay us less money than we would need to pay off our loan. An insurance company typically pays what the car is worth at the time of the accident or theft. And since a new car depreciates about 22 percent in its first year, the insurance company would likely pay us about $23,014 on the Explorer. Deducting whatever monthly payments we had already made, we'd still owe at least a couple thousand dollars on the car.

Once we paid that off, we would be back at square one: We would have no money to apply toward a down payment on another car. Some consumers would roll the remaining debt on the car into a new car loan. And then they'd be even more upside down in that vehicle.

Similarly, if we wanted to trade in our Explorer for a newer car a year from now, or if our financial situation changed and we had to get a cheaper car, having equity in the vehicle would allow us to sell it or trade it in without having to pay more money out of pocket.

20 Percent Down Payment
A 20 percent down payment on our Ford Explorer would be about $5,821. Though it may be difficult to save up that kind of money, 20 percent is still the sweet spot when it comes to a down payment. That $5,821 would cover most of the first-year depreciation and give us enough equity so we would not have to come up with additional money to move into another car, if we decided to do that. And if we had a theft or car-totaling accident, we would probably not owe anything on the vehicle.

No Downside to a Bigger Down
There's no such thing as a down payment that's too big. 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. Plus, for every $1,000 that you put down, your monthly payment will drop by about $20.

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 also about 11 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 2011 depreciated about 12 percent that year (versus a new car's nearly 22 percent depreciation). But don't count on that fact to help you if you try to trade in your car at a dealership. The value there will always be lower than what you could get by selling the car yourself, says Edmunds' Joe Spina.

Edmunds recommends that used-car shoppers make a down payment of at least 10 percent. That should be enough to cover a used car's one-year depreciation.

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. A buyer with a FICO score of about 670 and below will have a hard time getting an auto loan from a bank or credit union unless he makes 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.

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 totals the car. It will also help you pay off the car sooner.
• Look for new-car reimbursement coverage. A number of insurance companies — including Farmers, Allstate and Amica — have begun to 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 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.

A Final Tip
Keeping up with the Joneses is a race that few people will ever win. 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 are free to 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.