If you’re in the enviable position of having cash on hand to purchase something as expensive as a car, a boat, or even a property, why would you willingly borrow money instead of buying the asset outright?
It may come as a surprise, but wealthy people do it all the time, especially when interest rates are favorable.
The logic is simple: When you can borrow money at a lower interest rate than you can earn on money you invest, it’s cheaper to take a loan than to pay cash.
Still, millions of readers share the simple conviction that debt is to be avoided at all costs. If you’re one of them, it may be because you have experienced being over your head in debt like I have. Otherwise, you might have seen this happen to someone close to you, and you know the toll too much debt can take.
For the record, I mostly agree. Now that I’m able, I don’t have any debt. I purchased my cars with cash and paid off my mortgage. But I will stop short of saying I’ll never borrow money again. It will depend on my circumstances—and the interest rates—at the time.
The opportunity cost of spending cash
Whether or not you pay cash for a large purchase or finance it, there are costs in addition to the price of the asset. When you finance, the cost is obvious: it’s the interest you’ll pay on the loan.
When you pay cash, however, there is an opportunity cost in the future interest or investment returns you could earn from keeping that cash.
As a simple example, let’s say:
You have $10,000 in a savings account earning two percent APY a year that compounds monthly. In one year, you’ll earn $202. in interest. In 10 years, you’ll earn $2,212. Over 30 years, you’ll earn $8,212 in interest.
If you spend that $10,000, you forgo those earnings. By the way, with interests rates on the rise, you can get an even higher yield on your savings account. CIT Bank, for example, is currently offering 2.45% right now on their Savings Builder Account.
Things get interesting, however, when you consider that you should expect to earn a long-term average of six to seven percent on money invested in a balanced portfolio of stocks and bonds. Although actual returns are difficult to predict and depend on myriad factors, six to seven percent is a good rule of thumb.
At those returns, the opportunity cost for spending $10,000 goes up, and it goes up significantly when you consider the power compounding will have over time. At seven percent, you initial $10,000 will double in 10 years and earn over $71,000 over 30 years.
Example: Financing a car at 2%
Some of the lowest consumer interest rates can be found on new vehicle loans. Sometimes the interest rates are subsidized by auto manufacturers to help sell cars.
Even without subsidies, new car loans tend to be low because most creditworthy borrowers repay them and, in the event of default, it’s fairly easy for banks to repossess the car.
At 1.99 percent or less, it’s worth financing
If I were purchasing a new car today and had the option to either pay cash or finance the car at 1.99 percent or less, I would seriously consider financing it. For the record, I doubt you will find many 1.99 percent car loans at the time of publication. According to Bankrate, the average 48-month new car loan APR was 4.80 percent as of October 17, 2018.
If you do find and qualify for two percent APR on a new car today, you might consider financing. If you’re a stock investor, you should expect to earn long-term returns equivalent to a six to seven percent annual return. Therefore, if you’re earning seven percent and paying two percent, you’re netting five percent on your money, before inflation. On a $30,000 vehicle loan over five years, you could be better off by nearly $11,000.
Where to finance a car
First things first, you should never get a loan from the dealership—arguing with the salesperson about your interest rate will just give you a headache.
Instead, try searching for the best rates with loan aggregators like Even Financial. Even can find for you the personal loans that best match your needs.
Example: The sub-5% mortgage
The stakes can get even higher when you start looking at paying down a mortgage early or if you’re in a position to pay cash for a home.
Mortgage rates are going up, with the average 30-year fixed rate mortgage clocking in at 4.86 percent as of October 25, 2018. If they go much higher, this math starts to break down. But it still works, for now.
At five percent or less, take out a mortgage
At five percent or less, carrying a mortgage makes sense, in my opinion, for the same reason it makes sense to finance a car at two percent.
Even though you’ll pay a significant amount of interest on a five percent mortgage, you could still beat that rate by two percent with your investments. And, because you hold a mortgage for longer, the compounding effect is significant.
You’ll pay $380,375 in interest over 30 years on a $200,000 mortgage at 4.86 percent. Wow, that’s a lot. On the other hand, you could invest your $200,000 through M1 Finance, a hybrid robo advisor. If you earn an average seven percent annual return, which is feasible, you could end up with around $1.6 million. In other words, you could end up with nearly $1 million more than if you paid cash for the home.
Where to find a mortgage
But what about risk?`
When you look at the $200,000 mortgage example and the potential to come out ahead by close to $1,000,000, it’s easy to forget about the positives to paying cash. When you take out a loan instead of paying cash, there are two significant risks.
You could default on the loan
We all know that when you finance something, be it a car or a home, you don’t actually own it until the last payment is made. If you stop making payments, the bank can take the asset back.
Although the risk of default is presumably lower if you have the cash on hand to pay off the loan at any time, things could still happen. You could, for example, become incapacitated and stop making payments.
Your investments won’t always perform well
Historically, the stock market has been the best place to grow money over the long-run. But there’s no guarantee that will continue to be true, or that future average annual returns won’t fall. I’m betting my financial future on a stock market that can still return at least six percent over 30 or 40 years, so I’ll be among the deeply disappointed if this isn’t the case. But, you never know.
Determine the risk you can handle
When you pay off a four percent mortgage, or two percent car loan, you’re getting a guaranteed rate of return. You won’t be paying that four or two percent interest anymore.
As a result, like all investing decisions, it comes down to your risk tolerance. Taking on more risk has the potential to generate more reward.
Only you can evaluate your own situation and know what amount of risk is appropriate.
Don’t assume that paying cash for a large purchase like a car or home is automatically the best way to go. If you’re investing wisely and have excellent credit, you may be able to come out ahead by tens of thousands of dollars by borrowing money at a low interest rate and investing the cash instead.
There’s no hard-and-fast rule about how low an interest rate needs to be relative to your expected average annual return, but I think a two percent differential starts to become attractive and a three percent differential or more makes borrowing extremely attractive.