There are several articles out there on the topic of “Pay cash vs Finance”, which usually conclude that “it depends”. Or do whatever ‘feels’ right. But we won’t reach FI trusting our feelings (I know I can’t!). Let’s get the real answer.
Would you like to make some more money?
The truth is elsewhere
In mid-2011, when I purchased my current (used) car, I did not have enough cash in hand and I had to get a loan from my bank. Since I needed the car real quick, I didn’t think about it too long and I borrowed $20,000 from the bank at 2.25% for 36 months.
A few months later, after my cash pile built up again, I realized I could completely pay off the loan and have some cash left. The total cost of the loan was about $600 over 3 years and it seemed like the right thing to do to pay the loan off and save $600.
I saved $600, I felt smart.
My wife, did exactly the same thing and borrowed $20,000, from the same bank, at the same rate, for the same term of 36 months. But she did something completely different and decided to let the loan run its term. In fact, before the end of the loan, she considered extending it for another 24 months instead to keep the low rate, the great cash flow and invest the difference (the spread) in the stock-market. Wait,… does that work?
But… wait, that doesn’t feel right. Or does it?
After all, banks does this all the time. They borrow cheaply and resale it to you at a markup. We aren’t buying any other car any time soon, but I’d like to know what’s the best way to do this:
Is it better to Pay cash or Finance a purchase?
If you already have a loan, is it a good idea to pay it off early or not?
In most cases, cash is king and debt is a poison. But used carefully, debt can actually help generate money.
My friend Markus needs to purchase a new car and he too, would like to know how to best use his money.
Meet Markus. He’s broke.
Over the last few years, my friend Markus hasn’t really cared about money and as long as the pay-checks kept coming, he was just enjoying the life in NYC. The average American has a Savings Rate of 5%, he’s probably not too far and he has very little savings.
Life is great, he’s just got a new job in Houston. Moving from NYC to Houston, he realizes that for the time he’ll need to get a car. I take him around to visit a few dealership, he found one for 20,000$. With no savings in the bank, he’s thinking of getting a loan, as he’s done many times before.
He thinks about this for a minute and asks me for my opinion on the car. He’s a good friend, I give an honest advice: “Markus, look for a cheaper option. Don’t get a loan on a car you can’t pay cash. It’s a car, not an investment. A loan is a guaranteed loss.”
“Don’t get a loan on a car you can’t pay cash.”
My recommendation is for him to keep looking for cheaper options, until he finds one he can pay cash. A loan would be convenient, but it will eventually cost more and he’s already out of cash.
“Until I can pay cash…” he mumbles several times. I see him perplexed. Markus is a smart (and a little crazy) guy, it’s a sign he’s considering the idea.
The relocation Bonus
A couple days later, Markus rings me up and tells me he successfully negotiated a 20k$ relocation bonus with his company, because as he argued “you can’t actually work without a car in Houston”.
So now, he has just the right amount of cash to consider the following options:
- Pay the entire car with 20k$ cash,
- Get a loan, temporarily invest the excess cash and make the gains cover the loan cost.
The idea on the second option would be to put aside the equivalent of 12 months of loan payments, invest the remaining cash for 12 months and at the end of the year, withdraw the amount required to cover the payments for the following year.
Still with me?
The bank offered a 5-year loan at 3.35%, so he needs to find out what’s the minimum return his investments need to generate to cover his loan costs. And contrary to my original assumption, it’s not 3.35%.
It’s actually a lot more than that.
The loan costs 1,689$, so the investment will need to generate the same to break-even. Because it will be temporarily invested for 12-month, he will pay taxes on gains at every withdrawal (we assume 30%). I offer him to simulate how much such a temporary investment of his excess would return every year and compare this to other typical investments in the table below.
Markus’ temporary investments will need to generate 6% for him to break-even on the cost of the loan, or almost twice as much as the loan’s rate. He could even turn a profit of 3% (612$ on 20k$) if his investments generate 8%, like stocks could.
When I recalculated this table with different loan rates, I found similar ratios. A 6% student’s loan would require an 11% return on investment to break-even. A line of credit at 10%, like what you can get on LendingClub, requires 19% ROI to break-even.
his investments need to generate 2x the loan’s rate to break-even
As a rule of thumb for this scenario, I explain to Markus that his investments need to generate 2x the loan’s rate to break-even.
If like Markus, you are considering doing short-term temporary investments (<12 months) of excess cash in the stock market, with the intention to generate more gains than the loan would cost, I made some recommendation to him:
- If expected investments returns are above average (think 2008-2013):
- Use financing. Invest your cash.
- Only make the minimum payments on your loan, as long as the investments yield more than 2x the loan’s rate.
- If expected investments returns are average or below average (technically, most of the time):
- Pay cash. The financing option won’t be able to generate worthy returns.
- Consider re-paying your loan early, especially if it has a rate > 4%.
In short, if you have a car loan, a student’s loan or a credit card debt and you can’t afford to invest long term, then don’t invest and pay those debts off as soon as possible. It will statistically generate a better return to kill the debts than to invest. And pay all purchases cash.
Note : remember that a loan is a guaranteed cost, whereas the investments are only potential returns.
As Markus goes through this data, he starts to see that it is becoming increasingly difficult to justify the purchase of this 20,000$ car. The temporary investment of excess cash could work, but it is a somewhat risky bet.
However, there is still an option that we need to consider, where Markus could make money off the loan, like banks do.
Markus grows a Mustache
The main shortcoming to the previous investment strategy is that Markus has a low savings rate. Because the amount he can save every month is low, his future cash-flow can’t cover the additional loan payments. As a consequence, the investments can’t stay invested long-term and he needs to be withdraw part of it every 12 months.
If he wants to beat the bank, he will need to either make a lot more money or spend less, so that his future savings can cover the monthly loan payments while his investment keep growing.
Making more money takes time. Cutting spending is instantaneous. Markus decides to become more frugal and this will make all the difference.
With the same 5-year, 3.35% car loan, because the investment keep growing without incurring capital gains tax, the break-even has decreased 2 points to a little more than 4%.
Now this is becoming a lot more interesting because at 4%, you enter the guaranteed income territory of bonds, some dividend portfolios or alternative investments like LendingClub.
For his loan, the monthly payment is 361$. If the investments return 8%, the profit on the loan will be 1762$, or 29$ a month. If through a little more frugality Markus can save 361$ more a month and keep his investments in the stock market, he will have actually increase his net worth every month by 361$ + 29$ = 390$. Imagine the results if his investment is now in a 401k with a company match!
In this scenario, your investments need only generate 30% more than the loan’s rate to break-even. To break-even on students loans at 6%, your cash needs to generate 8% to break-even.
Now the good news!
Markus is generating an 8.8% profit off his 20k$ loan, if the stock market generates average returns.
Even if the stock market returns below average results at 6%, he would still capture a decent 4% profit. Since this is all about making money and not just breaking-even, if you have cash on hand to make the purchase and you can afford to invest it for the long term, the table suggests that :
- If the loan’s rate is > 5%
- Pay cash. The premium for Financing + Investing is not enough for the risk taken.
- Re-pay your loan early.
- If the loan’s rate is < 5%
- Finance and invest the cash equivalent of the purchase amount
- Consider letting your loan run its term.
In short, if you have a car loan or a student’s loan at a good rate and you can afford to invest long term, keep investing and re-pay the minimum payments. If you have credit card debt though, it is still a better investment to pay it off as early as possible. And consider financing all other purchases if you can invest the cash equivalent amount.
Note : interest rates are unusually low. When they rise again, I would recommend sticking to rule of thumb below
As a rule of thumb for Markus and the frugal folks who find themselves in this scenario, investments should generate 2x the loan’s rate to make money. This is a good baseline to quickly evaluate if there is an opportunity as everyone’s returns will differ based on their investment portfolio.
investments should generate 2x the loan’s rate to make money
When I saw Markus yesterday, he was smiling. A proud smile. A few days ago he was broke, he negotiated a relocation bonus to cover the cost of his car and now he has a plan to spend less and make money on the financing. As he confessed to me, looking at it through a frugal lens, he might actually go for a cheaper car that he’ll finance to increase his returns.
For all purchases of items that will not appreciate over time, like a car, student’s loans or other personal lines of credit, there is an opportunity to make profits on the financing as long as it’s cheap and that we actually have the cash on hand.
A few points can be concluded from this analysis:
- If your cash is ‘invested’ on a Savings Account at 0.1%, you should pay everything cash,
- There is no amount of investment that can justify not paying a credit card debt early,
- For most people, payments should be cash and debts should be paid early,
- For the Freedom Fighters, you should consider the financing + investing strategy to make money on the spread, if the investment can return 2x the loan’s rate.
When I got married, one good friend left me a note “Advice for the groom: your wife is always right”.
Turns out she was. Next time, I’ll let my car loan run its term.
Would you have other recommendations for folks like Markus who have loans or are thinking of financing a purchase instead of paying cash? Have you benefited from a financing + investing strategy before?