Credit Doesn’t Always Rate Better Than Cash

As the saying goes, something that seems too good to be true probably isn’t true, and last week’s column on car financing may be a case in point. Having gotten carried away with some suggested calculations, but not far enough, we omitted further salient factors and seemed to endorse the financial equivalent of a perpetual-motion machine.

Unfortunately, some things are immutable: Such machines don’t work. Nobody yet has turned lead into gold. And, at this point, there’s still no way a consumer comes out ahead if his loan has an interest rate higher than what he could earn on an investment.

Our original subject, a psychology professor, had the choice of paying for his new Toyota outright or taking the car dealer’s loan of $8,239.05 at 14.2%. He’d come out ahead with the loan, said the dealer, earning more on the money in an 8% investment than he’d be paying out on the loan.

Given the difference between 14.2% and 8%, this seemed to the professor “counterintuitive,” but the trick, as he figured it out, was that “the 14% is applied to a declining balance, and the 8% is on an increasing balance.” Thus, he’d really be borrowing $8,239.05 only the first month, zero the last, and over four years, the average outstanding balance of the loan would actually be about half the total amount borrowed.

Total interest paid out would be $2,607.62. His investment, on the other hand, would be left in for the term and compounded monthly, yielding interest of $3,095.06 and a profit of $487.44.

‘Intuition Is Right’

Unfortunately, says Gary Smith, Pomona College professor of finance, “intuition is right”: It’s only possible to come out ahead if one earns more than one pays out. Fortunately, the number of readers offering corrections was legion, as were their explanations--of “time-preference rates,” “time-value streams,” “classic internal rates of return,” the recomputation of “all future credits and charges for a common point in time,” the “interest income lost from a savings buildup achievable by not having to make monthly car payments.”

The clearest simply pointed out that the calculations ignored, as one said, “what money you are going to use to pay that loan off.”

There are two possibilities. The first is that $8,239.05 invested to balance the loan. But if money is drawn from it monthly for loan payments, it won’t all be gathering interest. Month after month, it will be reduced: “If you only pay interest on roughly half of the $8,239 loan, you really only earn interest on half of $8,239 also,” says Smith. “As it turns out, your money-market fund runs dry midway through the fourth year, and to make your last seven car payments, you must tap into other funds. At the end of four years, you are not $487.44 ahead but $1,399.21 behind” (seven months of payments plus 8% potential interest on the money).

One could also leave the fund alone, using other money for the loan payments. But if one does, that “extra” money must be factored in--48 payments of $225.97 plus, say, 8% interest they might otherwise earn, or $12,733.39 after four years. Weighing that against the $11,334.18 in the undisturbed investment fund, “you are again $1,399.21 in the hole,” says Smith. “It doesn’t matter whether each $225.97 monthly payment comes out of old savings or new.”

Better to Pay Cash

Someone in this situation would do better paying cash for the car, thus wiping out their $8,239.05 and any interest it might have gathered, but avoiding the $1,399.21 loss. And, if he has the discipline to bank the $225.97 he’d have paid on the loan, he could, in essence, pay back his own expenditure, and more. At 8%, he’d accumulate the same $12,733.39 figured above and be ahead $1,886.83 in interest earned, instead of behind. Even regular deposits into a 5.5% passbook account would put the consumer ahead about $1,300.

The only good financial argument for taking a loan when one could pay cash is if the same money invested could earn a higher interest rate than the rate on the loan--12% earned, say, vs. 8.8% financing, or 9.5% tax-free vs. 9.5% financing, or, depending on the tax bracket, even 8.3% tax-free vs. 14.2% financing.

There may also, of course, be practical concerns, including (obviously) an inability to pay cash. Even if one has the cash, if there’s a possibility one might need it in the coming months (job insecurity, perhaps, or the anticipation of new expenses), with no option but a loan at higher rates, the loan rate on the car and its ultimate cost might actually seem a better deal.