Let’s say you want to borrow other people’s money for a car purchase. You go to Bank A and they quote you a variable rate of 6%. You go to Bank B and they quote you 1.9% fixed. Which bank will you choose to do business with? Naturally you would choose Bank B. The cost of money is clearly less than Bank A.
Bank A is your portfolio. You have accumulated enough cash to pay cash for the car. Let’s assume your portfolio has averaged about 6% over the last 10 years or so. Why take money out of an account that has averaged 6%? Of course, we have no way of knowing what the future holds in store for us. But history would seem to be on your side. Additionally, by taking money from your portfolio, this may very well cause tax issues that are avoidable. (For more, see: New Wheels: Lease Or Buy?)
Bank B is your favorite local bank.
Let’s do some simple math. Your portfolio historically has earned 6%. The cost of the loan is 1.9%. Take the 6% earnings, subtract the 1.9% loan cost and you are ahead of the game by 4.1% Had you removed the money from the portfolio the “opportunity cost” plus the loss of compound growth and added taxation can easily do significant harm to your financial future.
Now, let’s change the scenario. You have savings at your favorite bank earning significantly less than 1%. The loan is still 1.9%. If you have enough to cover three to six months of living expenses in reserve, then take the extra cash and pay cash for the car, or at least pay down the loan. It makes little sense to hold “lazy money” when the cost of borrowing exceeds the earnings on savings.
Buy vs. Lease
All that sounds good, but the dealer is telling me he can get me into a lease and it will cost much less than buying. Let’s take a closer look. Lease is just a fancy way of saying “renting.” You have no ownership in the car. (For more, see: The True Cost Of Owning A Car.)
For example, that new car with all the frills will cost you $35,000. After 20% down you finance it for 60 months at 1.9%. Your monthly payment is $490 per month. At the end, you “own” the car. Let’s assume after depreciation the value of the car is $15,000. You can continue to drive it, or possibly sell it and use the $15,000 for a new vehicle. Either way you have an asset.
The lease on the other hand is $350 per month for 36 months, and an extra 15% lease payment. At the end, you have paid $17,850 and you turn in the car. Hopefully you didn’t exceed the very limited mileage allowance and the car is in immaculate condition when you return it. Either one could wind up costing you many hundreds or even thousands of dollars extra.
Now that you’ve turned in the car, what do you do? Do another lease or step up and buy another car? At the end of the original five-year period, the person who purchased and paid a little extra every month has the better deal. The only people who come out ahead on a lease are the dealers. You paid them for half the value of the car, and they will resell for the remainder, plus a handsome profit. In whose best interest in the car dealer working in?
It rarely every makes sense for an individual to lease a car, unless you think you need a new care every couple of years. There are better and smarter things to do with your money, other than buying cars every couple of years. (For more, see: Buying A Car: The Worst Investment?)