I’ve been asked to write a post to answer the following question:

Is it better to buy a car with cash?

And you know how I love a spreadsheet.

So, first, a scenario:

1. I’d like to buy a new BMW. After some negotiation, it’s going to set me back R440,000.
2. As a deposit, I’m going to trade in my existing BMW for R100,000. Oh – and I had to pay a R10,000 securing fee – which will also count toward the deposit.
3. So I’m in the red for around R330,000.
4. I have two options:
   1. Finance the car at 10% interest with a 40% residual value payment due at the end; or
   2. Pay for the car in cash.

So the argument that is often presented in these types of scenarios:

1. If you can earn a return on your money of more than 10%, then you should take the financing option, invest the R330,000, and earn the “spread” (being the difference between your growth in investment and your interest payments).
2. If you can’t earn that return, then you should just pay for your car in cash.
3. ± some transaction costs.

I prefer to think of this slightly differently:

1. The car is my investment. That R330,000 is already sunk into the BMW as it gets delivered.
2. By paying the cash, I am, in effect, earning 9% on my investment (because I’m saving the interest payments).
3. By taking the financing, I am forgoing the 9% return in favour of something else.
4. PS: I realize that there is a framing bias taking place here – but so be it.

To bore you with some technical detail, I’ve worked out the “net benefit” of using debt (instead of cash). And I played around with some scenarios:

1. You earn 11% constantly per month – I’m calling this the “Constant Return” scenario.
2. You earn 11% overall, but the market dips and swings each quarter (14% in the good months, 8% in the bad) – I’m calling this the “Volatile Market” scenario.
3. You earn 11% overall, but the market starts out booming for the first 30 months, and then does less well in the last thirty months – the “Slowdown Market“.
4. You earn 11% overall, but the market starts out slowly for the first 30 months, and then starts to do really well in the last thirty – the “Recovering Market“.

Of course, I use those terms extremely loosely, because I’m taking 14% as a proxy for a good time, and 8% as a proxy for a slowdown – and 8% is hardly a slowdown. But I want to point out that we’re talking about market returns, which are not the same as GDP growth (mainly because market returns are nominal and are not adjusted for the fact that they include inflation). A graph:

So anything more than zero at the end looks like the take-the-debt-and-invest strategy wins.

But.

And it’s a big one.

All this shows is that, if you expect to earn a higher return, then even if the market goes through some dips (and, like, even big dips), then you’ll probably be better off making an investment instead of buying the car for cash.

What it doesn’t show is what happens when the market consistently goes against you.

But.

And yes, it’s another big one!

There is also the implicit assumption here that the 10% interest rate is somewhat fixed. If it isn’t fixed, then you can count on the SARB to chase you on the gains and protect you on your losses:

• when the market does less well, the SARB will lower interest rates, and hurrah – you lose less (because your monthly repayments will go down).
• and when the market is doing particularly well, the SARB will increase interest rates, and dammit – you make less (because your monthly repayment will go up).

In the end, my feeling is that it’s generally better to finance your car (I just like debt finance in these settings). And for most of us – there’s no choice.

On the plus side, it also removes the admin of having to sell your car yourself at the end. And if any of you have gone through that rigmarole – I have done it once – then you’ll risk almost anything to avoid having to deal with secondhand car salesmen. Particularly when you’re on the sell-side of the exchange…

Thoughts?

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.