Why you shouldn’t buy a car with cash

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A few weeks ago, two friends told me that they were going to start buying a new car.

The research, frankly, is long overdue. Right now, the couple are sharing a small sedan that first hit the road with all of us still having bedtime. They affectionately call him “Daisy,” but it looks and smells much more like an old lemon.

They said they wanted to replace Daisy with a used one Subaru it would probably cost around $ 14,000. It would be their first big expense as a couple, but they said they weren’t too worried about it because they had the money to buy the car straight away, with no loan.

I begged them to reconsider their decision and started telling them that it was probably best to invest some of that money … on a Friday night.

I’m rehashing this conversation now, because I’m “that friend” and because a lot of people fail to avoid taking on debt without thinking about what else they could do with their money.

IMAGE SOURCE: GETTY IMAGES.

My friends’ cash-first mentality is the product of years of conventional wisdom telling them to avoid debt as much as possible. And in this particular case, why would they want to pay interest to gain access to a sum of money that they already have?

But when it comes to getting into debt, as with a lot of things, you need to learn the rules early on so you can break them once you’ve developed a good habit. Because the reality is, there is a cost to making a big cash purchase, and it’s much greater than the interest my friends might pay on a car loan they don’t pay. need.

The opportunity cost

Let’s say instead of buying cash they decide to put about 20% down for the car and finance the rest. We’re going to round the down payment here to $ 3,000, so they would be looking for a loan of $ 11,000. Someone with good credit looking for a loan of this size with a 60-month term would likely qualify for an APR – or cost of borrowing – somewhere between 3.25% and 4.5%.

At the high end of that range, they would spend around $ 12,300 in total to pay off the car. For the additional $ 1,300 they will pay in interest, my friends have an option. They can do whatever they want with the $ 11,000 they don’t immediately pay for the car.

Assuming they have built a comfortable emergency fundThis lump sum can be invested and they can make the monthly car loan payments of around $ 205 with the money from their paychecks. Here’s a chart showing how that $ 11,000 could grow over five years at different returns if they decided to put the money into a mutual fund or individual stocks.

Annual return on investment

Balance for year 0

Balance for year 5

Total gain

Net Interest Gain on Auto Credit *

3%

$ 11,000

$ 12,752

$ 1,752

$ 452

5%

$ 11,000

$ 14,039

$ 3,039

$ 1,739

seven%

$ 11,000

$ 15,428

$ 4,428

$ 3,128

9%

$ 11,000

$ 16,925

$ 5,925

$ 4,625

* Values ​​are before tax

Even at a meager annual growth rate of 3%, choosing to invest money could earn my friends over $ 400 more, after factoring in the interest paid on the loan.

It may seem counterintuitive that you can beat a 4.5% interest rate with a 3% ROI – the reason these numbers work is because the balance to which the higher interest rate is applied. is reduced over time, while the lower investment rate of return ends up being applied at an increasing basis. It is a fine example of composition at work.

If their money was earning closer to the historical stock market average of 7%, then their decision to finance the car and invest their cash would net them several thousand dollars more by the time they paid off the loan.

So, in the short term, there is an advantage in not buying the car with cash. But when you look at the long term, the numbers get staggering. This figure of $ 11,000 that I landed on before was not exactly arbitrary; two people only need to maximize their annual budget Roth IRA contributions for 2017.

If my friends decided to do that, they would pledge not to touch the account until they reached retirement age, which would give their money about 30 years to grow. Here’s another chart showing what that $ 11,000 could achieve at different rates of return.

Annual return on investment

Balance for year 0

Balance for the year 30

3%

$ 11,000

$ 26,700

5%

$ 11,000

$ 47,541

seven%

$ 11,000

$ 83,735

9%

$ 11,000

$ 145,944

Earning around the average market return, they would have four times as much money as they had initially invested when they started drawing on the account, thanks to a long term horizon and compound interest. And whenever they decided to withdraw distributions from it, they could do so without (probably) paying taxes.

From that perspective, the $ 1,300 they would pay in interest is minimal compared to the thousands of dollars of retirement money they would give up by paying the car in cash up front now.

It’s good to have options

I have already mentioned the optionality, and it is a luxury to have the money on hand. Saving thousands of dollars isn’t easy, so when the time comes to do something with it, it’s always worth weighing the options.

The investment is just one way they could use the money. If they already have credit card or student loan debt with higher APRs than the auto loans they would be entitled to, it might be a good idea for them to finance the car and pay off those other accounts with the money they owe. ‘they saved.

There are a few caveats to all of this:

  • The numbers won’t work that way for everyone weighing a car purchase. Unfortunately for people with average or poor credit, the higher the APR, the less likely it is that the returns on the investment will exceed the cost of the loan.
  • Financing the car only makes sense if you are confident that you can make the monthly payments for the life of the loan.
  • This average 7% stock return I cited is based on decades of data. There are five-year periods that crushed this average (like 2012-2017) and five-year periods that significantly underperformed it (like 2006-2011). This only reinforces the reason why it is better to consider a long term investment.
  • There is a golden rule to remember with loans: don’t let credit stretch your budget. In the case of my friends, they shouldn’t be willing to spend more than they originally planned just because they have access to more money.

Some people, even after going through the numbers, would rather buy the car straight away because they don’t like the feeling of having debt threatening them. It might not be the best financial decision, but again, having the money saved gives you the flexibility to choose your own adventure.

As Groucho Marx once said: “While money cannot buy happiness, it certainly allows you to choose your own form of misery. “

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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