Quote:
Originally Posted by silverlegacy
There are multiple factors when it comes to this, but here are the basics.
Let's be generous and say that a car loses 50% of its value over 5 years. That $25k car, just became a $12,500 car (using time value of money @3% that is 10,785 in today's money). So that $25k isn't being used for you, it is being used against you. It is being invested in a depreciating asset. You lost over $14k in value putting your money there.
Now there is the time value of money. A low, but good estimate here would be about 3%. So every year that passes your money is worth 3% less than it was the year before. It is smart to use that to your advantage. A 60 month loan $25,000 loan @ 2.9% is about $448 a month. By the end of that 5 years, that payment will be the equivalent of $386 in today's dollars (after 1 year that payment is already down to $435). In essence, if the interest rate is less than the time value of money, you actually start saving money the longer you borrow it. In this case the normal 3% out paces the 2.9% and the interest paid is nullified by decreasing worth of the dollar (barely as the difference is pretty low, so I will ignore the difference for the rest of this - if it was 0% it would make a much larger difference).
So now that you haven't used that $25,000 on a depreciating asset, and the interest costs are nullified by the time value of money, you can starting having that $25k work for you instead. If you put the money in a CD, you are not going to get the value out of it that you should, but let's just say you can get 1.1% on a CD. You have 26,405, but in today's money that is actually 22,783. That is a bad investment, but you still gained 12k in value over just buying the car outright. If you take that money and invest in some semi liquid assets in some stocks and bonds. Being conservative that should gain over 5%. That 25,000 then becomes 31,907, in today's money that is 27,530. A gain in value of $17k in today's money. Now if you really want to be picky you can include the total interest costs (which IMO are nullified by time value of money), on that loan ~1,900... so you could take that and subtract that out of the numbers above and you still make 10 and 15k respectively.
Now those are rough numbers, but should give the idea of what is going on. Even a low rate CD is advantageous over putting your money in a depreciating asset. All payments on depreciating assets should be delayed as long as possible as long as the time value of money outpaces the interest rate and in some cases as long as the time value of money + depreciation rate out paces the interest rate.
Clear as mud right?  |
I could agree with your logic if the question was "I have $25,000. Should I buy a car with it, or keep the one I have and invest the money in a CD?" To answer that question by saying that you'd be better off investing your money in a low yielding CD as opposed to a depreciating asset is perfectly sound reasoning.
The way I see it however, the question is "I'm buying a car. Should I borrow or pay cash?" It's a given that you're buying a car; the negative rate of return on that investment is what it is, regardless of whether you pay cash or finance it.
If you have the $25,000 and choose to invest it at 1.25%, but by doing this, it requires you to borrow $25,000 at 2.9%, your investment is yielding less than the cost of borrowing the money. The depreciation of the car doesn't factor in, since it's a constant in both equations.
To put it another way, here are the equations.
Rate of return for borrowing = ($25,000 @ 1.25%) - ($25,000 @ 2.9%).
Rate of return for paying cash = ($0 @ 1.25%) - ($0 @ 2.9%).