Low interest loan instead of paying cash from investments?

[HappyOutsourced]

Hello, I've posted several things lately but I'm new and have a lot of questions. You guys are a great resource and I really, really value your advice.
I often go with my sister when she visits her finance adviser.(I understand a little more of the lingo than she does and I always learn something when I go.) Last time she mentioned having used cash to buy a car. He said he thought taking out a loan and letting her investments pay for it overtime would have been the better way to go. What do you think? I know the more money she keeps invested the more wrap fee he gets. But is it good for the investor? Say you took out a loan for 5 years and let investments pay for it slowly. Would this be the withdrawal side of dollar cost averaging? Good idea?

 

[Meadbh]

My understanding is that the math shows that paying cash is generally the most cost effective way to pay for a vehicle. That said, interest rates and cash flows have some bearing on the situation. For example, if the cost of borrowing for the car is 1% and the cash that is not spent remains invested with an ROI of 8% it makes sense to borrow. That reflects current conditions. However if the cost of borrowing were 8%, that would be another story. If the buyer has tons of cash sitting around in a savings account earning 0.01%, it makes sense to buy in cash. In times of high interest rates, cash may get you a better price. Not recently though!

Disclaimer: I bought a car in 2012 with 0.99% financing for 3 years. I have had 4 cars in my lifetime and I have paid cash for two and financed two.

 

[Mulligan]

Interesting question. Anytime I need money like for example getting a roof which I am doing soon, I get an access credit card check and pay it back out of my monthly pension check. Just cashed one that is 3% with no advance charge and does not have to be paid off until June 2016 which is plenty of time. I am sure the most prudent way for me would be to take it out of my low interest bearing accounts and pay myself back. But I for some reason do not trust myself that I will pay it back. So I go this route. When it comes time for me to get another car and if I buy used, I will do it this way. Way easier than going to get a loan, and cheaper too. I get offers in the mail daily, so I can always roll it over onto another one if I don't get it paid off before offer expires.

 

[pb4uski]

It's really the same play as the pay off your mortgage debate. If she is willing to take the relatively minor risk that her investments underperform the loan interest rate she comes out ahead. One difference is that mortgage loan interest is deductible and car interest is not so if the gross interest rate were about the same then the economics would not be attractive. It might help her credit score if she cares about that.

That said, I pay cash for my vehicles and have for years.

On my last new vehicle, I got a $500 credit towards the car by financing with the manufacturer's finance arm and then paid off the loan a few months later. It worked great - you just need to make sure that there are no prepayment penalties.

 

[NW-Bound]

Even in low interest environment like we are in now, it's not difficult to find a place to get better returns than the 0.99% interest on car loans. My brother got a 0% deal when he bought a Honda for his daughter. No reason to pay cash when you get deals like that.

For these deals to be real bargain, I assume that they do not jack up the price to make up for that low interest rate, but I have not been shopping for new cars to know.

 

[Animorph]

I've done it frequently, home mortgage, HELOC, and car loans, all of which we could have paid off long ago or paid cash. As long as the interest rate is less than what you are expecting for your normal AA you can grow your portfolio higher by taking out the loans. Of course, you are taking on the risk that your portfolio might go down. Particularly with short-term car loans, you don't have much time to invest the loan balance. That will make them much riskier than something like a 30 year mortgage loan. Our two car loans were taken out in 2002 and 2009, both times I felt a several year investment would be a reasonable risk. All the loans have been worthwhile.

 

[Meadbh]

Even in low interest environment like we are in now, it's not difficult to find a place to get better returns than the 0.99% interest on car loans. My brother got a 0% deal when he bought a Honda for his daughter. No reason to pay cash when you get deals like that.

For these deals to be real bargain, I assume that they do not jack up the price to make up for that low interest rate, but I have not been shopping for new cars to know.

That is a generalization. My 0.99% loan is from Honda financing. I could have gotten a 0% loan on a Civic, but I did not wish to buy a Civic. I could have gotten 0% on a Toyota Corolla too, but I did not wish to buy one. The best deals are on the highest volume cars and you will usually not get them on cars that are at very high demand (which my CRV was).

 

[NW-Bound]

That is a generalization. My 0.99% loan is from Honda financing. I could have gotten a 0% loan on a Civic, but I did not wish to buy a Civic. I could have gotten 0% on a Toyota Corolla too, but I did not wish to buy one. The best deals are on the highest volume cars and you will usually not get them on cars that are at very high demand (which my CRV was).

My post was not clear, hence was misunderstood.

What I meant was whether the loan was 0% or 0.99%, one could find a place to get a better return for the cash than these low rates. And with the car makers being competitive as they are, there would be a reason why one would offer 0% compared to 0.99% as you explained.

 

[jkern]

I'm not a big fan of the idea for several reasons:

1) Investment returns are not guaranteed. Also, you cannot use a 75 year average Rate of Return to predict the next 5 years.

2) In order to compare apples to apples, you should use guaranteed returns like Banks/CD's for the next 5 years. Your after tax return will probably be 1/2 to 1%. Is your car loan lower than this?

3) You add a human element to it, maybe you cash out the investment and spend the money.

4) The intangible effect. Some people sleep better with no debt.

 

[NW-Bound]

A quick look on the Web shows that one can get 2% on 3-yr and 5-yr CDs, the length of a car loan.

 

[Meadbh]

My post was not clear, hence was misunderstood.

What I meant was whether the loan was 0% or 0.99%, one could find a place to get a better return for the cash than these low rates. And with the car makers being competitive as they are, there would be a reason why one would offer 0% compared to 0.99% as you explained.

Sorry, yes, I did misunderstand your post. You were referring to the opportunity cost of not having the cash to invest if one chose to pay cash for the car. In my case the difference (so far) between portfolio returns and the cost of the loan has been ~8%, so the car loan has been a good deal.

 

[HFWR]

I intended to pay cash for my Prius, but Toyota gave me a three-year loan for 0.9%. My j*b depends on grant money that is subject to drying up at any moment, so I thought that having that $25k in my pocket was better than having it sunk in a car. One more year and the car will be totally mine, and it was worth the $300 or so financing cost to have access to that cash if I'd needed it. The flexibility was worth it for me, under my special circumstances. YMMV...

 

[haha]

I'm not a big fan of the idea for several reasons:

1) Investment returns are not guaranteed. Also, you cannot use a 75 year average Rate of Return to predict the next 5 years.

2) In order to compare apples to apples, you should use guaranteed returns like Banks/CD's for the next 5 years. Your after tax return will probably be 1/2 to 1%. Is your car loan lower than this?

3) You add a human element to it, maybe you cash out the investment and spend the money.

4) The intangible effect. Some people sleep better with no debt.

+1. Using an investment portfolio to fund a car loan is huge maturity mismatch. There are exceptions too- for example taking the low interest car loan to avoid breaking a CD that you might have used to pay for the car.
Essentially time shifting

 

[2B]

If the amount of extra return you would make on the interest rate/investment return spread is worth worrying about, you are probably buying a car that is way to expensive for you. I'm personally not going to worry about a few percentage points difference in potential spread on a $30,000 loan. The loan balance is continuously falling so it would only average out at $15,000 over the course of the loan. Even at a 5% spread, it would only be worth $750/yr for the potential risk of not making the spread or the annoyance of another bill to pay.

I would have a different opinion if taking the loan got an increased rebate and you could pay off the loan without penalty.

 

[Meadbh]

If the amount of extra return you would make on the interest rate/investment return spread is worth worrying about, you are probably buying a car that is way to expensive for you. I'm personally not going to worry about a few percentage points difference in potential spread on a $30,000 loan. The loan balance is continuously falling so it would only average out at $15,000 over the course of the loan. Even at a 5% spread, it would only be worth $750/yr for the potential risk of not making the spread or the annoyance of another bill to pay.

I would have a different opinion if taking the loan got an increased rebate and you could pay off the loan without penalty.

Oh really? What you are implying is that if someone like me wants to get a good deal that will ultimately save several thousand dollars, it means she can't afford the car, despite the fact that the price of the car is ~ 1.1% of her NW. Just because someone is FI doesn't mean money should be wasted.

 

[eta2020]

A quick look on the Web shows that one can get 2% on 3-yr and 5-yr CDs, the length of a car loan.

I think if I pay cash I will be able to negotiate better deal with a dealer.

Also where do you see 2% 3-Year CDs?

 

[OAG]

I think if I pay cash I will be able to negotiate better deal with a dealer.

Also where do you see 2% 3-Year CDs?

Pentagon Federal Credit Union (insured by NCUA).

 

[clifp]

I normally pay cash for cars, but this last one Penfed was offering 1.74% for a 6 year loan. Considering that I have CD with Penfed at 3.5-5% and then just offered me 3 year 2% CD it seems like a now brainer to borrow the money.

Now I would think that if you are paying an adviser a 2% (gasp) or even 1% wrap fee that any modest savings you gain by interest rate arbitrage would be more than wiped out by the hidden fees.

Also taxes matter while the interest on mortgages and HELCOs are deductible, those on car loans are (although the 1.74@ even for a 50K car loan interest is only ~$450 a year on average and the lost tax deduction is small.)

The flip side is if you have a 3% 15 year loan and you have much of the money in dividend stocks say @ 3.5% the interest is deducted as ordinary income but the dividends are taxed at 0 to 15%.

 

[NW-Bound]

I think if I pay cash I will be able to negotiate better deal with a dealer.

Perhaps.

Does it make a difference if the low rate comes from the car maker, who's willing to take a cut on profits to compete? I have not been shopping for new cars for years, so do not know.

Also where do you see 2% 3-Year CDs?

Pentagon Federal Credit Union (insured by NCUA).

Yes.

For 5-year CDs, there are more choices for people not having access to the above CU. You can check at bankrate.com.

 

[eta2020]

Pentagon Federal Credit Union (insured by NCUA).

Not everybody can join it. I can not. Show me place that pays 2% CDs and is available to everybody.

 

[eta2020]

If you make deal simple for a dealer you will negotiate best deal and cash means simple.

Having dealer to go through paperwork of 0% financing will cost him and you. It is not free as it looks.

 

[eta2020]

Even if price of car is same and you find 2% CD this entire process is not worth effort.
Because:

Inflation will eat up 2%.
Feds will take on taxes 0.7% from your interest. State will take 0.1 %.

So you will end up -0.8% after going through needless paperwork's. It is not worth an effort. It is waste of time.

 

[2B]

Oh really? What you are implying is that if someone like me wants to get a good deal that will ultimately save several thousand dollars, it means she can't afford the car, despite the fact that the price of the car is ~ 1.1% of her NW. Just because someone is FI doesn't mean money should be wasted.

It depends on how much risk and trouble you want to go through to save the money. I used what I thought was a very high spread of 5% and the savings over the 3 year loan would be $2,250 (before taxes) if everything goes well. If you don't get the higher return, you don't get that much. If you happen to be late for a payment, you may lose the low interest rate or have it raised retroactively. You had to sit through the financing hassle with the dealer. So, your 1% of your net worth you spent on your car might save you 0.075% of your net worth spread out over several years. Take the safe route with a 1% spread to a CD and you save $450 (before taxes) at 0.015% of your NW over the 3 years. You can decide how aggressive you want to be and how much trouble you want to go through. In any case, I don't consider that amount of money worth worrying about when it requires me to take out loans I don't need. Also, I've not seen many instances where a lower price wasn't available if the low interest financing was not taken.

 

[NW-Bound]

Oh really? What you are implying is that if someone like me wants to get a good deal that will ultimately save several thousand dollars, it means she can't afford the car, despite the fact that the price of the car is ~ 1.1% of her NW. Just because someone is FI doesn't mean money should be wasted.

Hmm... I think we are thinking alike.

Just looked at my Quicken screen, which told me my AA at a glance. I have enough cash right now to buy both of my homes all over and still have money left over to get a small condo somewhere (darn, RE prices are still terrible according to Zillow, although they have recovered some).

But that does not mean I will turn away some money, if I were in the market for a new car.

Let's see. A $25K at 2% means $500/yr. After tax, which is low due to my financial arrangement, with that money I can get quite a few bottles of XO, or a few tanks of gas for my RV. I would say that it is worthwhile. I do not even drink that many bottles of XO a year!

About risk of late payments and the hassle of it, my wife-secretary-assistant has a way of arranging automatic payments for all of our bills. It is so that we would be traveling without having to worry about missing any bill. And it is my job to keep at least 2 months of expenses in the checking account to avoid the overdraft. Never missed a bill in the 33 years that we have been married.

 

[Meadbh]

Responses below in bold.

It depends on how much risk and trouble you want to go through to save the money. I used what I thought was a very high spread of 5% and the savings over the 3 year loan would be $2,250 (before taxes) if everything goes well. If you don't get the higher return, you don't get that much.

True, but my analysis of the markets has turned out to be correct so far.

If you happen to be late for a payment, you may lose the low interest rate or have it raised retroactively.

It's set up as an automatic deduction.

You had to sit through the financing hassle with the dealer.

Oh poor little me! It was a breeze.

So, your 1% of your net worth you spent on your car might save you 0.075% of your net worth spread out over several years. Take the safe route with a 1% spread to a CD and you save $450 (before taxes) at 0.015% of your NW over the 3 years. You can decide how aggressive you want to be and how much trouble you want to go through. In any case, I don't consider that amount of money worth worrying about when it requires me to take out loans I don't need. Also, I've not seen many instances where a lower price wasn't available if the low interest financing was not taken.

I had done a lot of research prior to making the purchase and this was the best deal available within 200 km. .