By BOB CUNNINGHAM
It is a common misconception that you should always pay cash on purchases. Old-school thought on this is simple and straight-forward: If you don’t have enough money on hand to pay the price, you can’t afford it and should save until you do.
Well, I’m here to tell ya that cash isn’t always king. In fact, many times it is detrimental to your personal finances to pay cash for purchases. And few people are as old-school as I am… or at least, as I like to think I am.
When you pay cash, there is this frequently overlooked factor called “opportunity cost.” On small purchases, like a combo meal at Wendy’s, the opportunity cost is pretty doggone small. But there is still an opportunity cost.
How does that work? Well, what if you use a cash-back credit card to buy your burger and fries? If the card pays 1% cash back, doling out a five and two ones instead of using the card just cost you about seven cents.
That’s $.07. Not much, of course. But if you buy lunch using the cash-back card five days a week, in a month you would have earned yourself $1.40, assuming you pay the credit card balance in full before the grace period of roughly three weeks expires. That adds up over a year to nearly $17 – enough for two free lunches, super-sized.
It should be obvious by now that I’m not calling your attention to this for such small fried potatoes. Instead, I’d like you to consider your next car purchase. Let’s say the ride you want costs $25,000. And for the sake of this discussion, let’s suppose you happen to have $25,000 saved and available. It’s invested in a stock market index fund inside at an online brokerage account and has earned about 7% since you’ve had it.
Very smart of you to put that money to work, by the way.
Meanwhile, the car dealership is offering 2.9% financing on that sweet-looking sedan. You have enough money to just pay cash for the car. Your parents have always told you to pay cash.
Listen to your folks? Or go into debt?
In my opinion, it’s a no-brainer… with all due respect to Mom and Dad.
If you opt to pay cash, you will have no car payments. And that is, of course, a good thing. It merits consideration, to be sure. But that $25,000 is now tied up, and thus can’t be used for anything else unless you immediately turn around and sell the car (which if you did, you’d be lucky to get $20,000 because new cars depreciate as much as 30% the minute you drive them off the lot according to KBB.com). So you’ve not only tied up the cash, but done so in a depreciating asset.
On the other hand, if you qualify for and accept the financing, and keep the $25K in the investment account, it would earn about $1,750 if it maintains a 7% rare of return (ROR) annually. The spread of a 7% return over a 2.9% interest debt is a net positive 4.1%. Mathematically, when the new car is paid off in five years, you will have netted a positive 20.5% (4.1% multiplied by 5 years).
Plus, you will still have the $25,000-plus if you need it for something else. It won’t be tied up in the formerly new wheels.
But hold on, you say. What if we need to make the $449 per month car payment from that same $25,000 account? OK… $449 times 12 = $5,388 in payments each year, with $388 of that being interest (we arrive at that by knowing the $25,000 cost of the car divided by five years equals $5,000 to principal per year, with the remainder being interest). So in the first year, and the subsequent four years, you pay $388 in interest every 12 months.
But how much did the index fund money earn you? The answer, considering the dwindling balance as we make those monthly car payments, ends up at about $1,400. That’s better than $1,000 more (the first year) to keep the cash and use it to make the payments as we go. We aren’t considering income taxes in our figures, because you’d have to pay taxes on the gains of the $25K at withdrawal, whether all at once or a little at a time.
The major key to the comparison is the 4.1% separation between the interest rate being paid on the car loan and the ROR on the investment account. Whether it’s the first year or the fifth, or anywhere in between, that spread is going to average out the same.*
*I’m not saying you can count on your cash to make a 7% return precisely, each and every year. Of course that isn’t the case. It might lose one year, but it also might make 30 percent gains the next. Determining which strategy is the best requires us to use constants (averages) where they don’t typically exist. If the investments in the account lose money in every one of the five years, then paying cash would have been better because we’ve lost that aforementioned spread. But five straight losing years is extremely unlikely. Historically, four of the five will be gains with two of those being at least 10 percent. (source – Morningstar.com)
Finishing with our example utilizing a 7% annual return on the investment account, in five years using the auto financing to pay off the car in full, we would still have about $1,900 remaining in the account (according to BankRate.com calculators) to go with a paid-off car that is now worth roughly 10-12 grand. Paying cash, you would still have a $10,000-$12,000 car… but the investment account would be fully depleted – immediately.
Look, nineteen hundred bucks versus zilch is a huge difference. So remember – opportunity cost is a big factor to look at when considering whether or not to pay cash for a purchase. For fast-food lunches, go ahead and use cash or your debit card. But on the larger purchases, be sure to take advantage of credit IF the rate of return on your saved money exceeds what the creditor charges to loan you the funds.
As always, thanks for reading.
DISCLAIMER: This post represents the author’s opinions only. In no way should any part of the content of this post be interpreted as official financial advice, nor does it represent an intention to solicit readers into a specific company or investment. Results are never guaranteed. Utilize the information as you see fit, make all money decisions at your own risk.