Owning a car is a necessity in American culture, but is going into debt necessary for it? Or is it even the smart solution? Well if we determine that for most of America it’s a necessity and realize that owning a car can get us to a job, or other highly valuable activities, it’s a pretty obvious that this is something most people will have to go through in their life. But the fact is too many people finance a car without looking at the opportunity cost of owning and financing a car.
The question of buying a car outright with cash or financing it does come down to personal determination and personal savings/budgeting. However, it’s generally the opinion of the authors that financing a car is generally not a great idea, but it can actually be a good idea depending upon your rates.
Let’s look at an example:
I’ve been looking around at cars recently and I found one I like – a 2017 Prius with 37,355 miles on it. It’s selling for $15,900. Now if I got a fairly normal car loan in the current market, I’d be looking at an interest rate of around 5% – give or take some depending upon your own personal credit rating. Now first we should determine what our monthly payment is going to be. I wrote up my own formula in excel to do this and I got the following:
So, we see here that my total interest paid for the six-year car loan would be $2,536.93 for a total cost of $18,436.93 over six years. That’s not terrible. And with the relatively modest sale price while using a 3-year-old car we can get a pretty great deal.
But my father always told me that the way to make money in this world was to be the one earning interest not paying it. So, let’s take a look at the opportunity cost of if we had invested this monthly payment of 250.07 for the same amount of time.
I’m assuming a relatively modest rate of return of 7.83%, this rate of return happens to be the same rate of return as one of my favorite index funds (Vanguard total world stock index fund). That index fund tracks the MSCI World Index and has an average rate of return, since Dec 31, 1987 of 7.83%. But, if we assume that this historical return will hold generally over the next six years. Then we can use that as our rate of return and as such, we get the below calculations:
Here we can see that, if we took our car payment and invested it monthly into VT, we would have gotten $23,438.15 for a net increase of $5,001.22. Meaning, we were better off to invest the monthly payment rather than pay it to a car company. And if we did that, we would have grown our wealth by $5,0001.22 dollars. This shows us the power of investing.
But for most people since a car is a necessity, I think a more interesting point to touch on is do we make a down payment or not. Well using the example, we have going here, lets take a look. If we ONLY invested our down payment as a lump sum into VT and never touched it again. Would we be better off?
Well the answer is it depends: it depends on the size of the down payment, interest rate, etc.
But continuing with our example, we can see here that, we should be indifferent to a zero down payment and keeping $1588.32 in the market. If you had in excess of $1588 in the market and thought about taking it out to put a down payment on this car that would be a bad move. This is because the amount generated in the market would end up being larger at the end of the loan than the reduction in payment you would get.
Let’s say you had $2,000 dollars and pulled it out of the market, at the end of six years this would have given you $3,194.47 if it remained invested. However, your financed amount would drop to $13,900 and your total cost of car would be $16,117.82. And your total difference in price between a down payment and without a down payment is $2,319.11. So, if we calculate the total the market would have made us $3,194.47 – $2,319.11 = we left about $875 on the table because we decided to make a down payment rather than keep the money in the market.
Finally, the last scenario we will look at is getting a very cheap car for about $5,000. But paying for it in cash and investing the difference between our total cost without a down payment. If you recall from the above, the total cost without a down payment was $18,463.93. If we bought a car in cash for $5,000 we’d have 13,463 left over for a lump sum payment into the stock market. This would give us $21,503.57 after 6 years. Or let’s say we broke this down into monthly payments which would be around $186.99 and invested that into the market for six years. We’d end up with $17,115.24 – almost the full price of our original fully financed car.
In conclusion, if you can make more interest by investing your down payment than the interest on your loan, it’s a financially sound decision to keep the money invested. However, if you aren’t sure this is possible or would just like more financial security, then it’s a better option to make a down payment and pay off debt.
When in doubt pay off debt but the power of investing should never be taken lightly. There are pretty tremendous opportunity costs to debt. It’s important to realize your costs and benefits when making any decision but particularly one that you’ll have for a long time.