Friday, December 29, 2006

SHOULD I PAY CASH OR FINANCE MY CAR?

Most people don’t have any choice except to finance their cars. However, if you are reading this column, the chances are you are in that fortunate higher demographic category and can afford to pay cash for your next car. People who read Op Ed columns in newspapers tend to be more intelligent and affluent. But, just because you can, is it the right move?

Many people think they can get a better deal on a car if they pay cash. This was true 40 years ago before dealers discovered the new profit center referred to as the Finance and Insurance Department. Today this is not true. In fact, paying cash may even make the actual vehicle cost you more! The reason for this is that car dealers make money when they handle the financing with the bank or with the manufacturer’s lenders like GMAC or Chrysler Credit. A dealer typically averages about $700 on every car he handles the financing on. Therefore, if the dealer’s minimum acceptable profit on a car was $1,000, he may sell it to someone who he could make $700 finance profit on for less than someone who he knew was a cash buyer. Dealers will sometimes sell a car for zero profit on the car because they can make a good profit on the financing.

One argument in favor of financing a car is being able to keep your money invested and earning a greater return than your interest cost of financing. The often overlooked fallacy is not making the comparison realistic by understanding that when you pay cash you are really “borrowing money from yourself”. If you have a 3 year CD paying you 6%, on $25,000, you will earn $4775.40 at the end of 3 years. If you finance a $25,000 car for 3 years at 6%, you pay only $2,379.80. But, to compare apples and apples you would have to pay yourself back for the $25,000 you “borrowed from yourself” to pay for your car. When you paid yourself back with interest monthly over three years, the interest you earned would equal the interest paid on the car loan. If you can earn more than 6% with your money, than financing the car for 6% would be a good idea.

One argument against paying cash for your car is that it becomes an asset of your estate and your net worth. This means that someone who won a lawsuit against you could seize your car for payment. If you had to declare bankruptcy, you could be forced to sell your car to settle your debts. If you owed the IRS money and could not pay, they could take your car. None of these things could occur if you had a loan on your car which offset the equity.

There is one very important intangible reason why some people should pay cash for their car. That intangible is called “peace of mind”. My older brother, Doug, grew up during the Great Depression. When he built his new house, he paid cash for it. I couldn’t believe this and was severely critical of him. It was entirely illogical for him to pay cash when he could get a very low interest rate and home mortgage interest is tax deductible. His investments earned him far more than the interest rate on his mortgage would cost. After a while I finally realized why Doug was right and I was wrong. He paid cash for his home because it made him feel better. Growing up in the thirties, like many of my customers did, made an indelible impression on his emotions. Owning his home with no debt made him feel happy and secure and what could be more important than that?

24 comments:

  1. Going into debt on a liability (a car is not an asset because it depreciates almost 20% annually) is a bonehead financial decision. Pay cash and never ever buy new unless your net worth is greater than $1M.

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  2. LOL...It IS an asset (it can be sold for cash); cars mostly depreciate in value, but some appreciate. The liability is the loan. Bonehead decision not to pay cash?...not if the yield is more on your investments than the interest you pay on the financing.
    Therefore with favorable financing terms buying new and financing could allow you to raise your net worth.

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  3. Yes, a car is an asset. The value, less the liability you owe against, is considered part of your net worth. Where on earth did you come up with the $1m figure of net worth?? That makes no sense. What if my net worth of $1m is tied up in real estate and long-term investments and isn't very heavily cash-laden?

    If you can pay cash for a car, you should do so if the cash you're using is earning LESS interest income than the interest you'd pay for a car loan. This is tough to predict unless you put money in a CD that locks in a rate. By the way, don't forget to factor in Federal and State income taxes on the interest income, which makes the analysis a little more interesting.

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  4. Dear Anonymous,

    I did not say that a car was not an asset. It is an asset; but it is one which virtually always depreciates, unlike a house, a stock, or a bond. Also, it is an asset that, if you finance it, usually has a negative or zero value for most of the time you own it. Thats because cars almost always depreciate faster than you your principal payments can build equity for 75% of loan period.

    I have no idea what you mean when you say you should finance a car if what you're earning on your cash investments is LESS tnan what it costs you to finance a car. Did you mean to day that?

    Re-read this paragraph from my article and maybe this will clarify things for you:

    "One argument in favor of financing a car is being able to keep your money invested and earning a greater return than your interest cost of financing. The often overlooked fallacy is not making the comparison realistic by understanding that when you pay cash you are really “borrowing money from yourself”. If you have a 3 year CD paying you 6%, on $25,000, you will earn $4775.40 at the end of 3 years. If you finance a $25,000 car for 3 years at 6%, you pay only $2,379.80. But, to compare apples and apples you would have to pay yourself back for the $25,000 you “borrowed from yourself” to pay for your car. When you paid yourself back with interest monthly over three years, the interest you earned would equal the interest paid on the car loan. If you can earn more than 6% with your money, than financing the car for 6% would be a good idea."

    Get it?

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  5. "One argument in favor of financing a car is being able to keep your money invested and earning a greater return than your interest cost of financing."

    Can you let me know where I can invest my money for 3-5 years at a guaranteed 6.5% return (after taxes)? According to Bankrate, the current auto loan rates for 3-5 year loans are 6.74 - 6.81% 5 year CDs are paying a little more than 3% (before taxes). Simply put, you would be hard pressed to EVER find a guaranteed after-tax rate of return anywhere close to the interest rates you'll be paying on an auto loan. In other words, you are better off paying cash.

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  6. I don't see the analogy of putting the money in a CD compared with financing a car. The problem if you put the money in a CD, you can't use that money to pay for your car. So you have to make sure you have a enough in the monthly budget to make payments. How about having 25,000 in a cd for three years earning you the interest then taking that CD and buying that car.

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  7. Dear Anonymous,

    When I wrote this column in 2006, CD's were paying considerably more than today, in 2009. And there was a much bigger spread between a CD and the rate for car loans. As you know, this severe economic crisis we find ourselves in has turned the yield curve upside down and what made sense 2 or 3 years ago does not today.

    But if you owned a CD paying 6% today [of course you can't] and financed a car for 4 1/2%, why take the money out of the bank and lose that good rate of interest?

    There is an argument that this is not a valid comparison because a car is a "depreciable asset" but that is only half the story. I don't consider an asset depreciable if you get equal or greater value to the amount of depreciation over the life of that asset. Also, you have a great deal of control over the rate at which a car depreciates. By selecting the right make and model and by properly caring for your car you can minimize the depreciation in more than offset it by the value you enjoy from its use.

    When you rent or lease a car, you con't care about its depreciation because you are getting the value of your daily, weekly, or montly payment for the length of time that you rent/lease it.

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  8. If you had financed a car a few weeks ago and put the cash in the market you would have made 30% already. 4 years worth of interest covered in a few weeks. Of course, a year prior to that and you would have lost your shirt! All that said, examine your risk tolerance.

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  9. Tiffany...let me guess. You're a loan broker!

    Loan brokers like you get paid a piece of the action by the lender. You have no incentive to advise a car buyer if cash is her best option. In fact, the rate you obtain even if cash is the best option is likely to be higher. The higher the rate you charge the bigger your commission.

    Please don't use my blog to market your questionable services.

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  10. What if you had bad credit?

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  11. is this a good idea? my wife and i are selling our house and buying her fathers. we will make about 30k off of the sell of our house. i will put 10k down on fathers house. we have a 15 passenger van that is paid for, worth about 10k on trade or 12 if i sell outright. we need something smaller, such as suv for our kids. we want a nice one as we plan on keeping it for at least 12 to 15 years. i want to take the 20k plus trade in and pay cash for a new vehicle. we have two other cars we just paid for and after 6 years of car payments, we want to only owe on our house. or would it be better to put the full 30k down on house and finance car?

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  12. also, we wont have to pay capital gains on our "profit" from our sale. we have lived here 7 years.

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  13. David,

    You have a very "good problem". Unfortunately few people these days have been as careful and frugal with their fiances as you and your wife.

    Interest rates are at historic lows. My guess is that you have excellent credit and can borrow money for a new car for 3% or less. You're probably paying close to 4% to your father-in-law on your home mortgage.

    It's hard to find a place to safely put your money these days that will earn you a safe 4% You can earn close to 3% with US Treasury notes. I would recommend that you finance your car for 3% unless you have a safe investment that would earn you more.

    It's almost a toss up and if you would have greater peace of mind by paying off your house, that would be the tie breaker.

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  14. So let's say I can pay cash for a new car, but decide to finance in order to get a better price. What prevents me from paying off the load in full on the 1st payment.

    Al

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    1. Thanks for your question, Al.

      Banks and most lending institutions penalize you severely for paying off their loans early. They use a mathematical formula named "The Rule of 78". Simply put, it means that the early monthly payments you make are applied almost entirely to the total interest due on your loan. It isn't until you get toward the end of the loan that you are paying more principal than interest. There is also a flat cancelation fee when you cancel a loan early.

      If you did save money on the price of the car by financing it instead of paying cash, you would likely lose more than you saved by the penalties for early payment.

      It's also no sure thing that a dealer would charge you less for the car because you financed it instead of paying cash. Whereas it's true the dealer makes more money when you finance it, that's not to say that he will offset that advantage because you finance. The dealer will just use that as an opportunity to make even more profit.

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  15. I know for a fact that loans with no early payoff penalties are out there. Both for my last three loans a camper and 2 cars purchase were both that way and were payed off prior to the first loan payment was ever made.

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  16. buy it on a credit card get your miles and then pay off with cash

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  17. Loans with no early payoff penalty are out there, but they are very rare and usually available to only those witht high beacon scores and usually not offered by banks. Credit unions are more likely to offer this. Remember that a bank does incur costs when a loan is paid off earlier than scheduled. They almost always will charge you, at least, a cancellation fee to cver their administrative costs.

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  18. I just read. Very interesting and informative, Earl. Thank you!

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  19. This comment has been removed by a blog administrator.

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  20. Hi Earl,
    I've been looking all over the internet for a take on this side of the story and have finally found it. Hopefully I'm not just happy to find you agree with me.

    So, if I have $19K to spend on a car, and there is a dealer with a special offering 0.5% (yes, half a %) finance for 36mths, then that is preferable to taking the $19K out of a mortgage offset account attached to a mortgage accruing interest at 5.99%...? This is on the assumption (and my intention) that it would be paid off within the 36 mths.

    From what I can see, it's even better as I am not paying tax on what I am saving, as would be the case if the money I'm borrowing from myself were in an interest earning account.

    Thanks for the interesting topic.

    E

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  21. Just one word of caution, E.

    You said "there is a DEALER with a special offering 0.5%." In most cases DEALERS don't finance cars. Banks and manufacturers' captive finance companies (Ford Motor Credit, Toyota Motor Credit Corp., etc.) do. If it is the dealer offering a very low finance rate, beware that he may be "buying down" the interest rate with the real lender. Buying down an interest rate means the dealer pays the bank an amount of money so that he can offer you a lower rate than the bank would normally permit. Of course the dealer passes this cost along to you by raising the price of the car.

    Be sure the low interest rate offer is truly coming from a real finance institution and not the dealer.

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    1. Thanks for your reply Earl. The finance is actually from Esanda so sounds safe.

      E

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  22. Hi. My husband and I are very seriously looking into purchasing a new vehicle, and we are having a difficult time determining whether we should pay cash or finance. We are young and both have good paying jobs. We have about $50K in savings, currently rent, and have no debt. We are looking at a vehicle that costs about $25K, so we have plenty to pay cash, and still have an emergency fund. But on the other hand, we don't know if it would make more sense to keep the money in the bank and pay a monthly car payment. What's the best way to decide whether or not to pay cash or finance? I like the idea of having the peace of mind of no debt, which we are used to. But I also am concerned about keeping savings for a bigger purchase, such as a home. Your thoughts?
    - K

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