We recently bought a 2005 Toyota Corolla with 21 K miles on it. Earlier, I did not disclose the price, but it will be relevant here, so let me say that we paid about $12,200 as the drive-out price [drive out price = final price after taxes and other fees]
We had the option of financing the used car at about 7.0% APR, but we still chose to go ahead with paying cash for it (a decision which I now question .. sort of).
One of the most important reasons for the cash payment was my almost-all-cash portfolio. The cash has been sitting there in high-yield savings accounts, but it hasn’t been invested in the stock market. So, although I have been making the cash work for me - it’s not realizing it’s maximum potential (which it would have realized if it was invested properly). Anyways, all that cash sitting there made me think - “heck, if I have the cash, why go for the auto loan?“. Plus, paying cash would be totally hassle-free, which further encouraged the decision. However, in retrospection, I am not convinced that it was a “money-smart” decision. I think we totally ignored the leverage aspect of the loan. Here are a few thoughts on the subject.
Paying With Cash
To the casual observer, not availing a car loan may seem to be the *smart* thing to do - because you won’t be paying a dime to the bank in the form of interest on your car loan. So if you car costs $X, you pay exactly $X and the deal is done.
But one has to keep in mind that, in doing so, you will be losing the earning potential of the cash (in our case we are going to lose the interest it was earning through the online savings accounts).
Let’s run some basic math (crude approximations), include the cost of lost interest, and see how much paying in cash will cost us over the next four years (that would have been our loan term).
- Cash paid: $12,200
- Car loan interest costs: $0
- Interest lost on cash (48 months @ 5.15% APR): $2790
- Total cost of the car: $14,990
Plus, paying with cash has a few psychological perks like not having to worry about paying additional monthly bills, not being “under debt”, etc.
Paying With Auto Loan
On the other extreme, if we had availed the car loan @ 7.0% APR, our numbers would have been:
- Cash paid: $0
- Car loan interest costs + principal (48 months @ 7.0% APR): $14,022
Interest received on the unspent cash (48 months @ 5.15% APR): - $2790
[read TFB's comment below - I knew something was amiss ]
- Total cost of the car: $14,022
What!? what happened here? I am definitely missing something. How does the car loan come out to be cheaper in the long run?
Well, there is one flaw in the above calculation - it’s in the assumption that the entire $12,200 is available for earning interest in savings accounts. You have to realize that you are paying off the car loan (with monthly payments of about $292) from the unspent $12,200 cash. So each year, your cash reserve goes down, and so does the interest earned on it. But even if you consider the extreme scenario in which you didn’t earn any interest on the unspent cash, the total cost of the car still comes to about $14,022 - that’s still cheaper than the first option. You could probably account for taxes in the first scenario and that way it won’t make too much of a difference (in our particular case). But, if you are earning say 8%+ return on your money in the stock market, going for a used car loan (typically around 6~7%) might be the best option for you, instead of paying cash ~ or that’s how I am figuring it out.
Of course, now that we have paid cash, we won’t have the “psychological” feeling of being under debt (in a Dave Ramsey style), but I am not sure if that’s worth about $900+ over the next four years.
Btw, if you don’t consider the cost of lost interest/returns, then it is obvious that paying cash is a better choice; but we are sort of going beyond that thinking in this post.
What do you have to say about this? am I doing the right thing in considering the cost of lost interest (lost returns) in the total cost of the car?