Friday, December 16, 2011

Paying Cash For A Car

One of the things you will hear almost every day on one the most popular cookie-cutter financial talk radio shows is that you should always pay cash for a vehicle. Is this always a smart idea?

Well, maybe but maybe not! I have financed cars and I have paid cash, so what I am about to share with you comes from real world experience. I will not get into philosophical views on debt because if your methodologies are based on religious beliefs, nothing will trump that no matter how the math adds up. This article is solely based on simple mathematics.

Let’s say you have $15,000 you have set aside and you want to buy a $15,000 new ride! Should you pay cash or finance it? 

Option 1: Pay Cash
NADA present value of the car: $15,000
Annual interest cost: $0
Monthly car payment: $0
Value of the car in 1 year: $12,750 (based on 10% depreciation per year)
In 2 years: $13,500
In 3 years: $12,150
In 4 years: $10,935
In 5 years: $9,841
Result in 5 years: $0 cash and a vehicle worth $9,841. That’s a loss of $5,159!

Option 2: Finance the car over 5 years at a 4% interest rate 

And invest your 15k in a 5 year Tax Free Government Insured Bond Paying 2% per year.

In 5 years, this would be the result:

Loan Balance: 0.00    
Car’s Value: $9,841 (same as above)        
Cash from Bond at Maturity: $15,000  
Bond Interest Earned: $1,500
Car Interest Paid: $1,575

Your car payment would be $276.25 for 60 months = $16,575

You would pay $1,575 (16,575-15,000) in interest but earn $1,500 on your Tax Free Bond = basically a wash!

BUT now you have a paid for car worth $9,800 and you still have your 15k!

I don’t know about you, but I like Option 2 over Option 1! 

It is really this simple? Of course NOT! But you CAN use leverage to your advantage even when buying a car. The major argument you hear against option 2 is that its too risky, so just pay cash. That's stupid! I would argue there is more risk of putting your money in a depreciating asset that turns 15k into 9k all to avoid paying $75 in interest. When people usually evaluate leverage they use mutual funds. That is too much risk. But in my example I use an insured tax free bond only paying 2%. There is virtually no default risk since its insured!

Another, statement I hear made against using leverage to buy a car is..."Rich people don't finance cars." Well, the stupid rich people may not use leverage BUT the smart ones who understand money and can add & subtract DO! I want to be rich, BUT I don't want to be a stupid rich person.

Important things to consider here… Cash flow levels: if it is not extremely likely you could easily make the monthly car payment then paying cash may be your best option. Also, if you are an extremely disciplined saver (most people are NOT), you could pay cash for the car now and pay yourself back over the next 5 years by saving $250 per month. 

The real point of all this is to get you thinking! There is more than one way to skin a cat in financial planning. Everyone’s situation is different! Don’t believe everything you hear or read when it comes to your money! Most people are ignorant on the subject. Most financial pundits want to “dumb” it down so they can sell you a book or a seminar. 

For more on how I can help you manage debt and risk, call me at 615-878-2134 or click

No comments: