I am looking at new cars and I could pay cash for the car. I also got a quote from my bank for a loan at 2.04% (48 months). My cash flow could support the loan payments. I am doing some analysis to see whether I should take the loan at that rate and invest the cash, or pay cash. The probability of earning significantly more than 2.04% is high over the next four years so it looks like I’ll take the loan and invest my cash.
Why doesn’t the bank do the same thing? Why don’t they say, “Screw giving a loan to CookingWithGas, let’s just invest the money and get a bigger return.” The only thing I can think of is that they see my ability to repay a secured loan is a lower risk than investing in the market.
Mostly it’s the duration of the loan. On the four year loan at 2% the bank gets back all of the principle plus the interest in only four years, then they can turn around and loan it out again. On a investment earning 5% it still takes 20 years to get all of your money back.
That’s pretty much it. Emphasis on the secured part, too. If you don’t pay, they take your car and sell it for cash, which may or may not be enough to get their money back, but still another option that reduces risk.
I’m out of touch, but 2.04% seems very low. That’s less than best-customer short-term rates I see quoted: commercial prime (3.5%), broker’s call (2.25%); and only slightly more than 5-year Treasuries (1.7%). Are you sure that this isn’t some promotional rate to increase car sales? (Yes, you said bank loan, but maybe there’s a kickback.)
Did you ask the car dealer what discount you’d get for paying cash?
My bank (USAA) is 1.5% for a 36-month loan right now (and that’s what I got it at a few months ago), so that doesn’t seem too crazy to me. (And their discounted rate if you use the car buying service is 0.99%). Actually, wait. Looks like it’s 2.25% for a 48-month loan, so that does seem a bit low.
2% is low, but not unheard of. My less-than-perfect credit got me 2.9% not too long ago.
Anyway, one of the things to keep in mind is the old supply and demand curve. If there is a demand for auto loans, but the banks don’t think it’s worth making those loans, then you expect the rate to rise until it is worthwhile to the banks.
The banks are simultaneously dealing with other supply and demand issues. There’s only so many corporate bonds, stocks, mortgages and student loans. If all the banks are fighting over a limited pool of lending/investments, then they drive the interest rate on those down. Mortgage rates are largely driven by the market demand for mortgage-backed securities, so the demand from investors limits how much can be put out there. At a certain point, auto loans start to look attractive again.
Because the bank, unlike most retail investors, does not optimistically discount the possibility of default risk, i.e. of losing some or all of the principal because that in which they invest – you, or some bonds or stocks – defaults. Their cold calculations tell them the rate of return less the fraction of loans that default add up to more than the same calculation applied to buying stocks or bonds.
Try to get a guarantee of 2% over a four year span in the stock market, it won’t happen. Over a decade, sure, 7% to 10% is pretty easy, but that short a span is a coin toss. Ask to extend your car loan to seven years and you’ll find out what the banks would charge for long term money. Short term loans have low rates because the banks expect interest rates to increase and want the money back sooner to turn over at a higher rate.
Banks are regulated* - they are not free to just invest in whatever gives the best risk-adjusted reward.
The assets that banks hold are given regulatory “haircuts”. That means, in a simplified fashion, that if a bank lends you $100, it might be allowed to borrow $95 of that money from somebody else, but the other $5 must come from the bank’s equity capital. This stops the bank from expanding its balance sheet indefinitely by an unlimited amount of borrowing and lending.
Of course, a sensible bank would do this anyway. But the problem is, when the economy is strong, there are no defaults, so bankers who take more risk just make more money. There is little market incentive to be prudent. So it has to be done through regulation.
To some degree, the regulatory “haircutting” obviously reflects the risk of the asset. A more risky type of asset attracts a larger haircut, thus giving the bank an incentive to demand a higher rate of return from risky assets, since they tie up more of its equity capital.
However, sometimes the haircuts (or other explicit regulations) are designed to just prevent banks doing too much of certain things. One of those things would be investing in the stock market. That’s because of the correlation between risks, and the importance of banks to the overall economy. If the stock market crashes, everyone is under pressure, people start defaulting on loans, and confidence can crumble, causing a feedback of more defaults. It’s important to ensure that in a market crash, banks are not exposed to the extra risk of losing massive amounts of money on their own stock portfolio. If people can at least be sure that the banks are safe and stable, then it’s much easier for businesses to hunker down in a crisis, and for confidence to gradually rebuild.
*All of this is what should happen in a sensibly run economy. In practice, well…
The financing is through my own bank, not the dealer. They get a check when I take delivery regardless of whether I sign it or the bank signs it. The bank does have some sort of arrangement with a number of franchise dealers that make it easier to do the transaction, but I have no idea if that involves some sort of incentives in either direction. They approved the loan and quoted me the rate before I told them who the dealer was.
It’s Bank of America. I have accounts with them and a pretty good credit rating.
(I just bought a used car last week and that dealer gave me 0% 36-month financing.)
Another point to keep in mind is that some banks make a lot of their money from regular old consumers like CookingWithGas and Richox - not necessarily large institutions or corporates. They will make money on this deal, sure. It wont send their share price rocketing or anything but its a OK deal. But it does get them a customer, maybe now you are a BoA person and you get a property loan with them next, hold your credit card with them (they start offering you advertising and deals and rates promotions because of this). So there is that overall idea of taking on customers and keeping them.
Also keep in mind the bank probably isn’t forgoing doing something else because they’e given you 10 grand for your car (p.s. it is their car until you pay it off hahah). They will both give you the 10k, and they’ll be doing everything else they want to in the meantime. This is icing on the cake stuff for them, within reason.