Last time, we discussed the decision some consumers are faced with when buying a car in that they’re offered a choice between a promotional interest rate or promotional cash back.
Another item to consider is: what happens with the promotional cash back?
Is it more beneficial to (as some dealers do) automatically put the cash back towards the price of the car? Or would it be better to keep the cash in hand?
The present value principle applies here as well. In this case, the main decision depends on whether one is receiving a higher return on their investments than the interest rate they’re paying on their debt.
The one caveat to this principle, however, is the conceptual understanding that cars lose a ton of value over time. This loss is called “depreciation,” and what it means is that you can buy the car for one price on the lot, and it will be worth a lot less as soon as you drive it off (as a hypothetical example).
This article from www.Edmunds.com illustrates how much a car depreciates over its life, and offers some advice on purchasing a used car.
Reference: “Beat the Depreciation Curve When You Buy Your Next Car”, Phillip Reed for www.Edmunds.com, 01/25/2016
Given this principle, it’s not necessarily a wise choice to apply the cash back to an investment and pay interest on the car, even if the borrowing rate is lower than the rate of return.
A good rule of thumb is this: if you don’t know how to calculate exactly how much more your investment return needs to be to justify paying interest on the car and investing the cash, it’s likely your investment’s return isn’t high enough to justify paying interest on the car – don’t invest it; pay down the loan.
For those who would like to get details specific to their situation, please e-mail the author for further guidance.
Just as well, if there are any questions, please feel free to contact the author either through the comments below, or through e-mail at firstname.lastname@example.org
© Fernando Machado, 2016.
Thursday, September 8, 2016
August and September mark the months where car dealers try their hardest to eliminate their outdated inventory in order to make room for the upcoming year’s models. To do this, they offer special deals such as the choice between a promotional interest rate for three to five years, depending on the dealer, or a certain amount of cash back.
How would one tell which option works out best for them? How would one optimize their choice?
To answer the question, one must consider the concept called “present value,” which can most easily be expressed as, “how much is $____ in the future worth today?”
If one wanted to receive $1,000 five years from now, and it’s assumed they get a 5% return on their investments, they would need $783.53 today.
Therefore the present value of $1,000 five years from now at a 5% rate of return is $783.53.
One can use Microsoft Excel, or a calculator such as this one on http://www.calculator.net to determine a present value of a lump sum.
Since the savings are a monthly payment made at the end of each month, on www.calculator.net, it would be the “periodical deposits” calculator that would be used, otherwise known as an ordinary annuity.
If the cash back amount is $2,000, to justify taking the promotional interest instead, the present value (not the future value) of the savings would need to be $2,000 or more, given the rate of return one receives on their best investment (which, let’s be honest, isn’t much these days for the average person).
As an example, a monthly savings of $30 over 60 months (five years), assuming an annualized 5% difference between the promotional rate and the conventional rate, yields $1,589.71 in present value. The total amount of the $30 monthly savings over five years is $1,800.
If one were to take the promotional rate here, they would be trading, today, $2,000 in exchange for $1,590. Or, if they’re patient, $1,800 five years from now.
Definitely a bad deal in this case.
One trick here is that the interest rate for which you would qualify for financing at the dealer may be artificially high, leading to a falsely primed decision to take the promotional rate.
For example, a loan that might be offered to you at 9% at the dealer would probably be available for 2% to 5% at your local credit union or bank. Even if the promotional interest rate is better than available borrowing rates, it’s not an indicator to take the promotional rate, but rather an indicator to shop around for a better loan.
Quick digression: Consumers in California are entitled by law to be offered the chance to purchase a contract cancellation option at the time of signing a contract for a vehicle, subject to a fee for the option and an additional restocking fee. While it’s a better idea to get pre-approved for financing beforehand, under pressure, this could buy a consumer some precious time to find financing, albeit relatively expensively.
The main things to consider are: 1) The higher the spread between the promotional rate and best available borrowing rates, and 2) the more expensive the car, the more the promotional rate makes sense. Otherwise, stick with the cash.
© Fernando Machado, 2016.