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How to buy a car with your tax refund

By Posted : 03/28/2014

Tax Refund written on road sign

Additional reporting by Aaron Crowe

The average federal tax refund this year is expected to be $3,120, according to the Internal Revenue Service. That's quite a bit of money, giving taxpayers many options for the best way to spend their tax refund.

That average tax refund on 2015 income is $4 more than the average refund last year on 2014 income, when a GoBankingRates survey found that 25 percent of Americans would use that extra money to buy a new car. If you need new wheels and a new car is on your wish list, then spending your tax refund on a car can make your money go a long way. A $3,000 tax refund is a 20 percent down payment on a $15,000 new car.

6 ways to use a tax refund for car-related purchases

A tax refund can be used to buy a new car, help afford a leased or used car, or reduce an existing car loan. Review six approaches to applying a tax refund on a car.

1. Use a tax refund for a car down payment

Interest rates on new car loans remain low, around 3 percent, although buyers with bad credit could face higher interest rates. But that's where applying a strong down payment from a tax refund can work to your advantage.

A substantial down payment allows you to demonstrate that you have significant "skin" in the game. This can help you get approved for a new car loan and result in a lower loan payment that fits comfortably into your budget.

A large down payment also reduces the likelihood that you’ll be “upside down” during the loan, meaning you owe more than the vehicle is worth when the vehicle's value starts depreciating.

If your tax refund is higher than average, congratulations. You can put more money down on a car and lower your loan payments. If your tax refund is lower than the average, you may still be able to afford a new car. Consider these examples:

Buying a $15,000 car with a five-year auto loan at 3% interest

Down payment

amount

Monthly loan

amount

$1,000

$254

$2,000

$236

$3,000

$218

$4,000

$201

$5,000

$183

Depending upon your circumstances, you may prefer to conserve your tax refund if you are comfortable with a higher monthly loan payment, or you may want to use your tax refund to make the largest possible down payment in order to minimize your monthly auto loan payment.

2. Use your tax refund to buy a used car

Using a tax refund to buy a used car won't give you the new car smell and other benefits of owning a new car, but it can save you a lot of money. If you shop wisely, you can avoid a used car loan and pay for the car outright with your tax refund.

Depending upon the age of the used car you select, it can be wise to have money set aside for repairs. Rather than making a monthly loan payment, save about $250 each month for future repairs.

Edmunds.com successfully tested a theory to buy a debt-free car and get at least 15,000 miles of use from it. For $3,400, or about the amount of a tax refund, a Forest Green 1996 Lexus ES 300 was purchased with 135,000 miles on it. Over 13 months of ownership, $3,286 was spent on maintenance, amounting to about $253 a month on repairs.

Finding a good, used car for $3,000 or so with less than 200,000 miles on it may be difficult, but it's possible. Take time to research available cars and wait until a great value car purchase becomes available.

Given potential repair costs for some used cars, you may want to apply your tax refund to other funds that you’ve been saving and purchase a used car in mint condition. It’s possible you could end up with a nicer vehicle than you might be able to afford if you bought a new car, while taking advantage of having someone else get some of the new car depreciation out of the way.

3. Spend a tax refund on leasing a new car

Your tax refund can be used to help you lease a new car. Leasing can help you get into a higher priced car than you might otherwise be able to afford, with a lower monthly payments and the ability to return the car after a two or three years. Edmunds recommends spending $1,000 to start a new lease, though it points out that starting a lease with a larger down payment can significantly reduce monthly.

Low monthly payments are often desirable. Some leases can be extended on a month-to-month basis at the end of their term. Check with your leasing company to determine if this option is available.

The difference between leasing and purchasing a car is illustrated below.

Example vehicle:  Lexus GS 200T, 2016 model

Base price: $48,160

Item

Leasing (36 months)

Purchasing (5 year loan)

Down payment

$3,299

$3,000

Monthly payment

$409

$822

Note that in the above example, the down payment is a little more than the average tax refund, but the monthly payment is about half that to purchase the car.

While a lease may appeal to someone who values low monthly payments, purchasing a car can be the preferred option for the buyer who wants to own a car beyond the term of a lease.

If you decide to lease, consider purchasing GAP auto insurance because your car may depreciate in value and be worth less than what you owe on it. If you're in an accident, this covers the difference between the current market value of your car that your insurance company should pay, and the amount you owe your finance company.

For example, if you put down $3,000 when you lease a new $20,000 car and total the car shortly thereafter, you may that you owe $17,000 on a vehicle that could be worth only $13,000 a year later. That $4,000 difference between what it's now worth and what you owe on it could be paid by GAP insurance. Without that coverage, you would be responsible for paying the $4,000 difference.

4. Use a tax refund to reduce your existing auto loan

Knocking down debts is often a priority when people what to do with their tax refund. Applying a tax refund to an existing car loan should reduce the amount of interest paid over time and making an extra payment toward principal should help pay off the loan more rapidly than originally planned.

For example, making a one-time payment of $3,000 on an existing $15,000 car loan is like making a year's worth of payments at once and can mean paying off your loan a year earlier. Ask your lender about the best way to do this.

Another option is to refinance your current car loan if the loan has a high interest rate. The tax refund could be used to reduce the principal and possibly get a better interest rate on the lower balance.

5. Buy an extended warranty with your tax refund

Another possible car-related use for a tax refund is to buy an extended warranty to cover repair costs. Many buyers never use their extended warranty coverage, according to Consumer Reports, so research this option carefully. Research shows that the average initial extended warranty cost is $1,214 while the median out-of-pocket savings on repairs covered by extended warranties is $837.

Still, if your tax refund is a bit of a windfall and you fear that you may have difficulty covering unexpected repair costs during an extended warranty period, or worry that repair costs for your vehicle could exceed the median, purchasing extended warranty protection may give you important piece of mind.

6. Buy better auto insurance with your tax refund

Before you can drive your newly purchased car home, you typically have to prove to the dealership that you have at least minimally-required car insurance.

This is a time to consider your full insurance needs and apply a portion of your tax refund toward upgrading your existing coverage. If you didn’t purchase comprehensive and collision auto insurance before, find out about the cost to add it now. Improving your insurance coverage may be possible for only a few hundred dollars, leaving the bulk of your tax refund available for other uses.

The type of car you drive is one of many factors that auto insurance companies consider when setting rates. Insurers look at how safe your car is, how much it costs to repair or replace and how likely it is to get stolen, among other things.

Penny Gusner, consumer analyst for Insure.com, outlines insurance requirements as they relate to financing your vehicle; in cases where you have flexibility, your tax refund may enable you to afford the best possible coverage.

Buy the car outright: If you have the cash to do this, you can opt for any coverage you want, as long as it meets the state's minimum auto insurance requirements.

Use a loan: Since a lienholder wants its asset protected, it will require you to cover damage to the car and carry collision and comprehensive in the policy. You may also have to keep the deductible under a prescribed amount, typically $500 or less. And, of course, you'll still need to buy at least the required state coverage minimum.

Lease the vehicle: Because the auto is in the leasing company's name, it will require you to carry higher liability limits of $100,000 per person and $300,000 per accident for bodily injury liability and $50,000 for property damage liability (100/300/50). And as with a finance company, the lessor will require you have collision and comprehensive and may limit your deductible amount.

How to spend your tax refund on a car

Your tax refund can be an important component in buying or leasing a vehicle, protecting it through an extended warranty or via robust insurance coverage. If your tax refund is sizeable, you may be able to apply it to more than one car-related purchase, such as making a down payment on a new car and compare auto insurance quotes to buy the best coverage for it.

Whether buying a new or used car, or leasing a vehicle, it’s important to shop for your car insurance as you shop for the car.   A leased vehicle will require higher liability limits (100/300/50) and both a leased and financed vehicle will necessitate that you carry physical damage coverages, such as comprehensive and collision insurance. If you’re used to a bare bones policy on an older car, your car insurance rates will be considerably higher. Even if you already have comparable coverages on your existing auto policy, the car you’re purchasing may cost more to insure. The type of car, its safety and claims record, repair costs and value are all taken into account by car insurance companies, and affect your rates.  

If you shop for car insurance while you shop for your car, it may help you narrow down the vehicle that you choose (based on how much insurance costs for each car you evaluate). Avoid surprises when it comes to your premium amount. Be sure you can afford both the car and insurance payment before you commit to a car.

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