This one is a follow up to last week’s – Should You Invest or Pay Off Debt? The comments on that post are very interesting; you should check them out if you haven’t seen them yet. Some people prefer to pay off debt and others want to optimize by investing. If we purely go by the numbers, investing with other people’s money is a great way to make money. This is only good with low interest loans like mortgage and auto loans. It’s a bad idea to take money from your credit cards and invest it because you can’t beat the high interest rate. However, we’re not robots. Emotions and psychology dictate how we behave. I could have taken out an auto loan and used the extra money to invest, but we didn’t do that. We paid for our current car in cash and chose the safe route instead. That’s because I loathe auto loans. Why do I hate auto loans? Read on…
Our current car
Our current car is a 2010 Mazda 5. It’s a small minivan. We got it new in 2010 and paid about $17,000 for it. We could have taken out a car loan with near 0% interest, but we didn’t want to do that. I’ve had auto loans before and I despise sending in those monthly payments. First, let’s look at the numbers.
No to auto loan
My credit is great so let’s say I could get an 84-month loan (7 years) with 3% interest. We’ll use 3% just to make it more realistic. I think the 0% was some kind of promotion. If I paid for the car in cash and avoided the 3% interest. Here is how much I’d save.
- Total loan interest of $15,000 at 3% = $1,650
So I would have saved $1,650, not bad.
I’m not sure if 3% is realistic for an 84-month loan. The internet tells me it might a bit higher than that, but we’ll just keep going. The rate is highly dependent on your credit score.
Yes to auto loan
On the other hand, I could have taken that $15,000 @ 3% loan and invested it.
We’ll make it easy and go with VFINX, Vanguard’s S&P 500 index fund.
- VFINX 7 years ago: $92 per share
- VFINX (8/1/17): $228 per share
The stock market had a great run over the last 7 years and gained 250%. That $15,000 would have turned into $37,170. It sounds unbelievable, but it’s true. I’m using real numbers here. If you’re not an investor yet, you need to start investing as young as you can.
Profit = Current price – purchase price – interest paid = $20,520!
Oh wow, that’s a huge difference. Actually, this is a bit too simplistic. (I realized it a bit later and came back to fix the numbers.) Let me try again.
A better calculation
The problem is I’d have to pay back the auto loan every month. It’s not like I could invest the $15,000 in VFINX and pay back the loan at the end of 5 years. What we have to do is sell a few shares every month and send $198.20 to the bank. After 5 years, the loan will be finished.
Here is a cool graph.
I used the $15,000 and purchased VFINX. Then sell a few shares to pay back $198.20 every month. After 84 months, we ended up with about $11,000 in profit. That’s smaller than $20,520, but it is still an awesome gain.
Of course, the stock market has been on fire. It’s hard to lose with that kind of gains. Hindsight is 20/20.
*Taxes – I didn’t take taxes into account. The gain would be less than this due to the capital gain tax, but probably not by a huge amount. It’s too hard to calculate tax because of the different tax brackets.
What if the rate was higher?
As long as I have the spreadsheet, we might as well see how it’d worked out with higher interest.
15% credit card debt to invest
Obviously, it’s not a good idea to use credit cards to invest. It’s very difficult to overcome that expensive 15% interest rate.
8% margin loan to invest
We’d end up with $6,200 profit, not too bad. Personally, I don’t like margin loans either. I think 8% is too high and the margin call really sucks. That’s when the brokerage makes you sell your stock to pay off the margin loan.
Why I hate auto loans
Going by the numbers, it’s likely that you’ll make a profit if you can borrow at 3% and invest it in the stock market. However, I didn’t do that because I hate auto loans. Here are the reasons why.
Temptation to buy more
My credit score is awesome so the bank is more than willing to give me an auto loan. They would love to collect more interest. If they’re willing, why not get a nicer vehicle? We could get a BMW X5 for $65,000 instead of a Mazda 5. The BMW X5 is a much nicer vehicle and it would impress our neighbors and friends. This option can be very tempting to most consumers.
That’s how they lure you into borrowing more and buying a car you can’t really afford. I suspect this trap is working quite well because the auto loan is a huge part of the US non housing debt. (see graph below)
I made some financial mistakes when I was young too. I got a BMW Z3 instead of a sensible car. We loved it and enjoyed tooting around in a cool convertible. It was an awesome car, but I didn’t like making a car payment every month. Also, the repair and maintenance bill was much higher than a regular car. I enjoyed owing a cool sports car, but I won’t buy another one until I can pay for it in cash.
Are you really going to invest that money?
In the example we went through above, I invested the $15,000. But, come on! How many people have the discipline to do that? Most people would take that $15,000 and spend it on something else like a jet ski. That’s why so many families are in debt today. Americans are horrendous with money management. Give them $15,000 and it will disappear in a few months. Retire by 40’s readers are the rare exceptions, of course. 😉
A Depreciating asset
A car is depreciating asset, especially a new car. Our Mazda 5 would have been worth less than the loan the moment I drove it off the lot. That’s a huge difference from a mortgage. Real estate usually gains value over time. Most of the time, you can sell a home and have a nice little lump sum left over. That’s not true for auto loan. You end up owing money if you have to sell the car.
It’s a bit better for used cars because the biggest depreciation is already gone with the new car smell. It’s funny to realize that I paid 20% of the purchase price to breath toxins… Next time, I’ll buy a newish used car instead.
The last reason I didn’t want a car loan was my early retirement plan. In 2010, I wasn’t sure when I could quit my job and I wanted to be conservative with our cash flow. The best thing to do when income is uncertain is to minimize your monthly expenses. I cut back on everything and minimized our expenses. $200/month isn’t much when you have a well paying job, but it’s huge when you don’t have steady income.
The stock market has done extremely well over the last 7 years, but you never know how it’s going to perform next year. What if the investment tanks? It would impact my early retirement plan. At that point, I prefer to take the sure thing.
Do you have a car loan?
Investing with other people money is a winning strategy when you can get low interest loans. So taking an auto loan and invest it is pretty smart, but there are some pitfalls too. I choose to make it simple and purchased our car with cash. No car loan means less stress and that’s our ultimate goal.
What about you? Do you hate auto loans? Why or why not?