Most personal finance pundits will tell you that if a purchase does not produce income and depreciates, it's bad debt. They'll also tell you that you should avoid bad debt wherever possible, buying things like cars up front with cash. At first glance it sounds like great advice - by never going into debt, you completely rule out the possibility of ever being underwater. And to be honest, in most cases it is good advice, specifically for the financially inexperienced or those who have trouble managing debt.
However, as an investor this logic seems to be at odds with the time value of money and the opportunity cost of your money. To better understand the total financial picture associated with purchasing a liability, let's build and analyze some scenarios to explore just what the difference is. Here are our assumptions for purchasing a car:
- You want to buy a car that costs $40k
- The car will depreciate at a rate of 15% per year
- Homes in your area and rental rates each appreciate at 2% per year
- You can get a 5-year car loan with no down payment for 3% APR
- You can get a 30-year mortgage on a 200k property with 20% down payment for 5% APR
- You can reasonably expect 10% cash-on-cash return from 20% down on a $200k property with the seller to carry closing costs
Financing vs. cash purchasing is not necessarily as straightforward of a calculation as you might think. As an investor, you should be aware that every purchase carries with it an opportunity cost - if you decide to purchase the car outright, that's $40k you don't have available to invest. Therefore, lets look at it as if each decision is a set of two investments (one for the car, and one for the property), each with independent cash flow and equity:
In Scenario 1, the car is bought for all cash, leaving no money left to invest in property. In Scenario 2, the car is totally financed, and the $40k is instead used as a down payment on a $200K property with a 7.2% cap rate. Over the course of 5 years, by choosing to purchase this car for cash instead of financing it, you're paying almost 80% more (31k in this example) for your vehicle in opportunity costs! Not to mention after the car loan is paid off, you now have a property that is cash flowing around $4.5k per year.
I'll admit that when I ran these numbers, I was pretty surprised at just how much money can be saved by being cognizant of the opportunity costs, even with conservative numbers for investment returns. However, it's important to note that the reason most personal finance gurus recommend paying cash is because this strategy involves significant levering. You're essentially going into debt on a car just to allow you to then go even further into debt on a property.
So how do you know when it's a good idea to finance big purchases like a car and when to pay cash? If most or all of the following apply, you might want to seriously consider financing that next big depreciating purchase:
- You have a high tolerance for risk and are able to take on significant leverage. In the above scenario, the debt service for both the car and property in the second scenario was around $1800/mo. If you don't have a plan in place for how you're going to cover this in the event of prolonged vacancy or some disaster, you're setting yourself up for financial ruin.
- Your liability loan has a lower rates than your property loan. If you're able to score an auto/personal/HELOC loan for significantly less APR than a property loan, this might be a good way to take advantage of the difference. Don't think you can rationalize paying credit card APRs with this strategy and end up ahead.
- You can get significantly and consistently better returns from your investments than you will lose through depreciation. If you don't plan on investing with your saved up funds, have no saved up funds, haven't taken the dive on your first investment yet, or think you're going to work this by investing in mutual funds, you might want to reconsider.
- You actually need to buy a liability. The first question you should be asking yourself when you're thinking about buying a liability like a new car, boat, etc. is whether or not you actually need to buy it. At the end of the day it's still a liability that will lose you money over the long term, intelligently financing it is just a means to mitigate losses.
- You've actually run your numbers. Don't just assume that because you get good returns on your investments that this is always a good idea for you. Like every other investment, run your numbers for your opportunity costs so you can make an informed investment decision.
When it comes to making large purchases, it's important to consider the whole financial picture. We hear so much about good debt and bad debt from the financial gurus, but that's just a simplified picture. In reality there is no good debt or bad debt - there's only cash-on-hand, debt, and the opportunity costs and risks of trading between those two. Every purchase you make is an investment decision, whether you think of it that way or not. Taking the time out to consider your opportunity costs and risk tolerance for large purchases can save (or make) you a significant amount of money in the long run.
Agree? Think I'm crazy? Let's hear it!
