Car Loans & Interest Rates
Last night I had dinner with some of the dads from our son’s class. A fun time was had by all, with our conversation centering as it usually does around Elon Musk (don’t ask), EVs & other cars, the world economy, and our kids’ upcoming soccer seasons.
One of the dads needs to replace a family car because his lease is coming due in a few months. He is a big Tesla fan, and is considering a Model Y. We have an ongoing argument about the relative merits of Tesla vehicles vs Musk’s lunacy, but that’s a subject for another post, in another place.
The reason I’m writing here is because his next question was directed at me, the, “finance guy:"
“Stoj, what should I do about a car loan?”
Now, our little group is not a bunch of cotton-headed ninny-muggins. We have two former fund managers, entrepreneurs, a CEO, and executives in tech & manufacturing industries. But, “simple,” financial decisions often aren’t that simple. In fact, one of the ironic things about personal finance is that the things people see as most complicated, like investing, should be the least complicated, while decisions like this, whether to borrow or pay cash, can be quiet complex.
So, what are the decision points around purchasing a new car right now, like this pretty Model Y?
Before the Federal Reserve began raising interest rates to fight inflation, the decision of how much to borrow to buy a car was fairly easy. If you had good credit, loan rates were low enough so that the simplest answer was generally to borrow as much, “free money,” as possible.
Keep in mind that this is completely different from spending as much as possible on a car. The car should always fit comfortably within a prudent budget.
Now, however, with loan rates significantly higher, it’s a much more difficult question to answer. Or is it? As the resident finance nerd, what did I do? I got out the financial planning software to make some models.
The first thing you have to do when creating any model is to decide on your inputs & assumptions. As an old computer programmer, I know we want to avoid GIGO, or garbage in, garbage out. So what are our assumptions?
Car price: $55,000 (Long Range Tesla Model Y with a few options plus tax)
Car Loan Rate: 6.58% (average rate as of August, 2023)
Monthly Payment: $716 (average new car payment as of August, 2023)
Another key assumption is that the buyer has the cash available to make a sizable down payment, or even purchase the car outright, and can cover the $716 payment plus any state tax without dipping into savings. Our job here is to calculate the relative impact of loan size on possible net worth over time.
Scenario 1: Purchase car with $10k down payment, $45k loan.
Under this scenario, it takes just over six years to pay off the loan, and you invest $20k that you otherwise would have used for a down payment in a low cost index fund. I used Vanguard’s Total Stock Market ETF VTI for the calculations, with JP Morgan’s Long-Term Capital Market Assumptions for return expectations. Of course, we know that no one can predict the future, but we need to assume something. That’s how models work.
Scenario 2: Purchase car with $30k down payment, $25k loan.
Under this scenario, it takes just over three years to pay off the loan, but the additional $20k used for the down payment was taken from your investment in VTI.
In both scenarios you have the use of a nice new car, and make the same monthly payments for the life of the loans. How is your net worth affected in each scenario? Well, as it turns out, keeping that additional $20k invested over the life of the loan adds almost $15,000 to your net worth over the life of the loan.
What if you’re super disciplined & as soon as you pay off the smaller loan you begin investing that $716 you were using for the payment each month? Guess what? You’re still $10k behind where you’d be with the larger loan!
In the end, what we’ve really demonstrated is the value of compounding. Time in the market is your best friend.
Of course, disclaimers here include the usual past performance is not indicative of future performance, as well as the important assumption that the buyer is making a choice whether to leave funds invested vs using them to make a larger down payment. If a buyer doesn’t have that excess capital, then it would be difficult to recommend anything but taking out the smallest possible loan.
The key takeaway for me is that even higher loan rates alone, unless they are above investment returns, are not a reason to make a larger down payment, or to, “just pay cash,” if you’re able.
