Thursday, September 8, 2016

Cash back or Promotional Interest? – Part 1

August and September mark the months where car dealers try their hardest to eliminate their outdated inventory in order to make room for the upcoming year’s models.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 to determine a present value of a lump sum.

Since the savings are a monthly payment made at the end of each month, on, 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.

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