re: spinoff thread - why pay off a car as soon as possible?

So you let your feelings dictate your actions?

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They cannot. There is no mathematical answer that says paying the car note is better (unless it is an unusually high APR). Literally the only answer is that it is a risk hedge or psychological benefit.

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I think you mean there is no mathematical answer that says paying the car off up front is better, right? In other words, financing for a good rate over a long enough term is the way to go? If so, I agree.

I think people often overlook the term, and typically they err on the wrong side. If you’re contemplating financing vs pay cash, and assuming those funds are invested, then the longer the term, the better for you. Beating 3% or so on a note is a lot easier with more time on your side. The shorter the term, the more risk you’re taking

Gotcha.

The direction of this thread is pretty predictable. People hate debt more than they like making good decisions. They think debt is to blame for what is actually a spending problem.

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You have to consider the fact that a house generally appreciates, yet a car generally depreciates (massively). The interest rate plus the depreciation rate is your hurdle, and that’s a massive one.

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Why. Does. Depreciation. Matter.

Buying a car, period, is a shitty purchase. That doesn’t change depending on how you pay for it. It depreciates regardless of how you pay for it. That’s not a hurdle.

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Does the car depreciate less if you pay cash?

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People REALLY hate debt.

You’re 100% correct when you say it’s a spending problem, not a debt problem.

If you’ve worked the numbers and figured out what you can afford, then financing usually works in you favor (assuming you aren’t paying an insane interest rate).

Generally speaking (and ignoring risk), if your unlevered return on an asset exceeds your cost of debt financing, the use of debt increases your return on that asset, and vice versa. You also need to consider what your opportunity cost is (i.e. the rate of return you could earn by spending $1 less on a home or car note and instead investing it elsewhere).

For a home, the use of debt is a very easy sell in a low interest rate environment. That's because the rate of return you can earn elsewhere (i.e. your opportunity cost) plus the annual appreciation on the home, when combined, are likely to exceed your after-tax cost of debt (as an aside, recall that interest is tax deductible for a home, but not for a car).

For a car, it's a negative yielding investment to begin with. The average depreciation rate on a car is something like 16% per year for the first five years. That's a pretty massive hurdle to overcome via using debt to finance that depreciating asset and hoping to earn a higher return on the dollars saved than what you're losing on the car itself. Do you think you can earn 16% per annum? And even if you could, that's just going to get you to breakeven.

Here are the 4 scenario I ran:

Scenario 1: Put 20% down on a house; finance the rest with debt.

Scenario 2: Put 100% down on a house; no debt.

Scenario 3: Put 20% down on a car; finance the rest with debt.

Scenario 4: Put 100% down on a car; no debt.

Common assumptions across all 4 scenarios:

1. Cost of debt = 3.5%
2. Marginal tax rate = 24% (this factors into your tax shield on mortgage interest, but doesn't factor into your car interest; it also factors into your capital gains on opportunity cost (i.e. dollars saved by using debt and investing elsewhere)).
3. Holding period = for consistency's sake, I'm assuming 5 years for both the house and the car; at the end of 5 years, you get the useful life of the asset back
4. I'm not assuming any maintenance expense in any of the four scenarios.
5. Opportunity cost of capital (i.e. how much you could earn by investing vs. paying cash for the house/car) = 9.0% (equal to the long-term nominal rate of return on stocks which, particularly in today's environment, is likely generous).
6. In scenarios in which debt is used, you invest the cash saved via the use of debt at your opportunity cost ROI.
7. In scenarios in which debt is not used, your cash savings in Y1 through Y5 which result from not having a note are all invested at your opportunity cost ROI.

Uncommon assumptions:

1. For the house, I'm assuming it appreciates by 2% p.a. - likely conservative.
2. For the car, I'm assuming it "appreciates" by negative 16% p.a. - also conservative. See here.

Here are the house scenarios. Given that your ROI + annual appreciation on the house > cost of debt, you're much better off using debt to finance a home purchase (IRR of 14.0% with debt vs. IRR of 3.0% without debt).



Here are the car scenarios. Given that your ROI + annual "appreciation" on the car < cost of debt, you're much better off NOT using debt to finance a car purchase (IRR of -14% without debt vs. IRR of -21% with debt).



TLDR: Put as little money as possible into cars. If you're a spendthrift who can't help yourself, take the money you'd otherwise spend on a nicer car and use it to buy a nicer house.

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People REALLY hate debt.

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I LOVE debt. But only when it's used to increase value.

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I don’t think anyone believes it is a risk free decision. That’s a straw man.

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Agreed, but it's not quantified. I'm just highlighting these decisions are never as simple as 7%-5% = profit.

With respect to the calculations you ran, a few questions:

1) For scenario 3, I wouldn't run the ROI on the $40k. The ROI would be on the $40k minus the car notes. As a result, it would be on a declining balance and not growing as you're showing. I know that makes the math worse, but it's more accurate IMO.

2) For scenario 4, how/where are these positive cash flows happening in the investment financials? You wouldn't have any money left. You used it to buy the car. If you use all of your money on an asset with a -16% rate of return, how can you possibly get an IRR higher than that?