Rich people don’t finance automobiles. If you don’t have the cash, you can’t afford the car. Save for a couple of months if you need to.
Recently a lawyer friend told me about a new car purchase. On a five-year loan, he locked in a 2.84% interest rate and felt pretty good about it. After all, you can make more money in the market right? This is one of those no-brainer decisions. Not so fast.
14 reasons to pay cash
I suggested he pay cash for the car and came up with 14 reasons why it makes sense to pay in cash. Actually, I came up with less reasons at first but then had a great Twitter conversation with a reader recently and decided I needed to develop a few more reasons before posting.
1. Simplicity. Buying a car on credit means one more payment to track. Even if you set it on autopay, you still have to monitor the payment, budget the payment and otherwise make sure the payment is made on time. Pay for a car in cash and that problem evaporates. Don’t underestimate cognitive load and the associated cost. Less is beautiful.
2. Cars Depreciate. Cars are not assets. The value decreases as soon as you drive it off the lot and eventually a car will be worthless. Why finance something that will be losing its value? I’d rather stick with financing actual assets that I expect to appreciate over time, even if only keeping pace with inflation (like a house).
3. Interest. Obviously! Why pay interest when you don’t have to? A $30,000 car is going to generate $852 in interest a year. That’s a new iPad every year. I’d rather have the iPad than pay a bank.
4. Finance Charges. Buy in cash and you won’t pay them.
5. You’ll Buy a More Expensive Car. This is simple human nature and backed by many studies. We humans spend more money when making a purchase on credit than we do when paying with cash. Why put yourself in that situation to buy more car than you want just because it’s on credit or because you can afford the monthly payment?
6. Higher Sales Tax. Buying more car than you intended? You’ll also pay higher sales tax.
7. Higher Insurance Premiums. More car also means higher insurance premiums to protect the car.
8. Higher Registration Costs. That’s right – the fees just keep adding up. A more expensive car could lead to higher registration costs, depending on how your state calculates registration fees.
9. Cash Flow. If you’ve decided to leave a certain amount invested to beat the return on financing the car, you still have to come up with the monthly payment to service the car loan. That means adjusting your budget and restricting your cash flow. I prefer to have as much flexibility with cash flow as possible.
10. Mistakes. Accidentally miss a payment? Doesn’t even matter if it wasn’t your fault. One mistake and you could ding your credit score or incur a late payment fee. Why take the risk?
11. Less Buying Options. Buying a used car? Good luck finding a private seller who is interested in waiting around for you to get your credit union on board with the sale and wiring the money. If I’m selling a used car, I’m expecting you to show up with cash.
12. Living Debt Free. If you have student loan debt and a mortgage, you know what it feels like to live with debt. That means you probably value the time before all those things when you were debt free. Why turn back the clock? It’s liberating to live debt free and you don’t get that feeling with a car loan, even if you have the money in savings to pay off the loan.
13. Making the Spread Isn’t as Clever as It Seems. So you’re making the difference between your return in the market and the 2.84% you’re paying on the car loan. Let’s say you’re making a 5% real return (8% total return, but losing 3% to inflation). On a $30K loan that’s $1,500 a year. Nice. But wait, it’s in a taxable account, right? So you have to pay taxes on that interest. Your actual return is more like $900 after taxes. Suddenly that $852 in interest you’re paying to bank doesn’t look like such a good deal – you’re only really making $48 a year!
14. Finance Everything. If it makes sense to finance a car, why stop there? The logic should extend to everything – you should be financing your next vacation, home furniture, iPhone and kid’s education.
I get it, sometimes financing does make sense
I’m not suggesting that debt is so evil that financing never makes sense. Forgoing contributions to your 401K to pay down a 1.9% car loan is not a smart move. The problem is that the behavior economists are all over this – financing leads to greater expenses and it’s an easy trap to fall into.
If these reasons don’t convince you, there are worse things to do than finance a car. A young lawyer making $100K+ a year should be able to save up for a car pretty quickly. It’s likely you can cobble together the money within the time it takes to research and finance a car anyway.
Once you buy that car in cash, start making monthly payments to a car savings fund and you’ll be ready to buy the next car in cash once you’ve driven the current car into the ground.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.