When Borrowing Is A Good Thing (Part 2)

When Borrowing Is A Good Thing (Part 2)

I posted recently my analysis of the pay cash vs. borrow for buying the Jaguar, and received a couple of interesting responses from readers. One reader thought it made more sense to spend $5000 to $8000 (cash) to buy a used Subaru, rather than a Jaguar. The problem is that a $5000 to $8000 used Subaru around here means at least 80,000 miles or more--enough that the Subaru is well out of warranty, and realistically, you can expect at least a few substantial repairs on a car that age. The Jaguar is still under factory warranty, and will be for a couple of years. That alone is a strong case for the Jaguar.

The more substantial criticism of my analysis is that I was ignoring the income stream that I would enjoy from paying cash for the car, and putting those car payments that I am making into savings every month. I had completely overlooked that. It does change the equation a bit, but not quite as dramatically as you might assume.

What doesn't change: there is still a net $2738.94 interest income from the 4.30% APY CD (after paying federal and state income tax on the interest at a marginal rate of 33%). The total interest paid over 60 months on the car loan is $2458.23. But what interest would the $335.97 per month payment accrue over those 60 months?

Remember that the 4.30% APY CD was because I locked that interest in during November--and I would not get that interest rate today--and the way things are going, not likely again for another year or more. Also, that rate required me to lock it in for five years. While some of the early car payments could be locked in for five years, and get a roughly similar situation, the vast majority of those payments would be in the second, third, fourth, and fifth years. Unless I was locking up that money for five years (which is not a comparable situation), I would never get 4.30% APY--not even close. Furthermore, my credit union has a minimum $500 balance to get CD rates that high, so at least every other month I would just have the money sitting in a demand deposit account, at a much lower rate.

If I managed to earn 3% a year on the money that would otherwise be going to car payments (which seems extremely unlikely, with current interest rates), I would only have a net interest income of $1029.11 over five years--and I would be forgoing the $2738.94 net interest income that the $17,700 would have earned in the CD.

So, if I keep the money in a CD, and make payments: $2738.94 CD income - $2458.23 car loan interest = $280.71 net income. If I had paid cash, and broken a couple of CDs: $1029.11 net interest income (and that is making the optimistic assumption of 3% yield) - $2738.94 lost CD income, for a net loss of $1709.83. Even with a completely unrealistic 6% yield as I put those "car payments" into savings, this still comes to a net loss of $611.38 over five years.

So, what about the supposed rule that you should never make payments, if you can afford to pay cash? If there is a big difference in interest rates between CDs and loans, this might be true. Under some economic conditions, this might be true. If you don't have a spectacular credit score (my FICO number is 819), you may get stuck with such a high interest rate that you would be better off paying cash. But my guess is that many people that can afford to pay cash for a car probably also have a pretty decent credit score. (Okay, drug dealers might be the exception.)

I am adding the spreadsheet for modeling this here. This should apply to any loan where the interest is not tax deductible. Houses and student loans require different treatment--I may work on that as I feel more energetic.

I have updated my discussion of How To Become Wealthy with this at the very end.

UPDATE: One reader noticed a slight formula error; I made appropriate adjustments.