Burning Cash for a Car?

Lewisburg, PA – The total amount of the current US auto loan debt level has surpassed $1trillion and is currently $1.092trillion! Some believe that this, along with student debt, is the next bubble. So, what is the best way to pay for a car, cash or by financing with a loan? Most people that you ask would probably say to pay cash.  Most would say to pay for everything in cash to have no debt at all if you can.

What many people forget about is opportunity cost and arbitrage. Opportunity cost is a benefit that a person could have received, but gave up, to take another course of action. Banks use arbitrage every day when they take your money in deposits and give you 1% or less, but then turn already and give it to someone else for a loan at say 7%. That 6% difference is the arbitrage and how they make trillions of dollars. They profit by using their debt. On top of that, banks borrow even more money from the Federal Reserve then loan that money out at a higher interest rate as well.

Why can’t you do the same? The answer is you can if you are disciplined and actually have the cash saved and have it invested in an interest bearing account at a higher rate than the financed amount. If you have good credit and income, you could very well get an auto loan at 2.4% or less. Then let’s say you get market returns of 6%. Historically very achievable over 5 years if you are globally diversified, disciplined, and getting market returns. The interest rate arbitrage would then be the difference in having an auto loan at 2.4% and possibly earning 6%.

Let’s give you an example: Say that you have 30k saved up for a new car purchase. If you were to just pay cash you will be giving up the chance for that 30k to be growing at 6%, your opportunity cost. Over 5 years that 30k, earning 6%, would have grown to 40k, so your opportunity growth is 10k if you were to just pay cash.

Now many people would say, “Well you would be saving on interest though!” Over a 5 year auto loan at 2.4% APR, you would only have a total interest of $1,866. Would you give up 10k to save $1,866? That is a total opportunity cost of about 8k and if you pay cash you my as well just take 8k to a burn barrel. In just one year, you would essentially have the same amount of money in growth to pay total interest of the auto loan (30k x 6% = $1,800). In your lifetime, the average number of cars for a family is 11-15 which would be a total of possibly 120k lost in opportunity cost if you pay cash and even more with the compounding interest over your life!

Another option is that you could even withdraw the payments directly from that investment account of 30k. The auto payment for a $30k car with an interest rate of 2.4% would be $531.10 a month.  If you were to withdraw that from the 30k, that is earning 6%, each month then you would still have over $3,400 left at the end.

Essentially, you would be acting like a bank. You are borrowing from one person and investing at a higher interest rate somewhere else. Again, this only works if you actually invest the money and are disciplined. Compound interest is really powerful, small savings really add up!

Please don’t hesitate to reach out for some coaching advice on your specific scenario and to learn more tips.