Paying cash vs. taking out a loan

In My Humble Opinion
1

I don’t need an answer fast as this isn’t about a pending transaction. It’s more a question of philosophy, or maybe fiscal wisdom, and I’m interested in others’ points of view.

Scenario #1 - you want to buy a car that costs $25K. You have $50K in savings, so it’s doable in cash, and you won’t leave yourself without reserves.

Scenario #2 - you want to buy the $25K car but you only have $30K in savings.

Scenario #3 - you have no savings and you inherit $30K and you want to buy the $25K car.

Scenario #4 - you have 3 months of living expenses in savings and you inherit enough to pay off your mortgage - do you pay it off or invest/save the money? What if you were living paycheck-to-paycheck, but by paying off the mortgage, you effectively get a “raise” in the amount of your monthly mortgage payment?

My husband and I discuss our finances periodically, especially now that we’re both giving serious consideration to retiring, and the opposing sides of the issue come down to having a cash cushion or being debt-free. There are many variables that seem to block a one-size-fits-all answer, including some we’ve probably not considered, hence my question.

Do you have a rule of thumb about when to pay and when to go into debt? What points do you consider when making the decision? In the long-term view, do you factor in possible inheritances or the sale of current assets?

2

It depends on the rates and your personal situation. Is that $50k in savings a cash (or near-cash) reserve in addition to your retirement accounts? And how are those doing? Are you 25 or 75? With good credit, a few-year car loan costs very little. So I am inclined to borrow and move excess cash into longer-term investments.

But if we’re taking credit card rates, better to use cash.

Most of your scenarios I’d say I can’t afford a $25k car.

Paying off a mortgage early often doesn’t make good economic sense, but again it depends on the specifics.

3

My brother is a bit of a financial whiz and he agrees that paying off your mortgage early isn’t smart. I have a hard time wrapping my head around that, especially since the interest on the loan is such a large component and even itemizing, you don’t get it back dollar for dollar. And for what we owe, it’s academic anyway.

But let’s say we get an unexpected windfall that would pay it off - isn’t it smarter to own your home outright? If you’re careless with your money, you’ll just blow the inheritance anyway, but instead of blowing a giant chunk at once, you’ll just fritter away the former monthly payment. And if you invest, is risking the windfall better than making smaller contributions to an investment every month? To me, not having a house payment is a good thing. Same as not having a car payment is a good thing, as long as you’ve got that emergency cushion.

And an additional thought - does it make a difference if you’re just interested in being able to support your lifestyle as opposed to trying to build wealth?

One thing for sure, I wish I’d thought more about these things when I was in my 20s - in my 60s, it almost feels desperate. Not that we’re worried about having to move into a refrigerator box or anything, but I expect if we’d planned better 40 years ago, the picture would be different now. If I knew then…

4

You have to run ALL the numbers to see what works for your situation. I paid my house off quite early because we: 1) Had plenty of available cash beyond the payoff, and 2) The tax incentive was lower than the Fed standard deduction. So in my case, why service a 5% debt? Paying that off is akin to making 5% on the money.

We are retired, and pretty much purchase for cash now. Recently we bought new phones, and instead of paying them off $10 per month or whatever, I just paid them off. Why? I can’t stand owing anyone anything.

YMMV, and good luck!

5

My husband is a financial advisor. On paper, it rarely makes sense to pay a lower interest debt ahead of debt with a much higher interest rate, but even more so for mortgages because mortgage interest is tax deductible. (And if your investments aren’t exceeding your mortgage rate right now, then you should refi your house (we just locked in 3.875%) and/or find a new financial advisor!)

It makes even less sense for people who have underfunded their retirement account to pay off their mortgage early, because you’ll be losing out on all future income associated with that block of money.

However, he’s also learned that people are emotional creatures. Just as some people shouldn’t own single stocks because they cannot handle the stress of the inevitable ups and downs (actually just the “downs”) of the stock market, other people simply cannot “relax” about their financial well-being until their mortgage is paid off.

If you really would feel more comfortable paying off your mortgage, then by all means make plans to do so. That doesn’t necessarily mean paying it off today, especially if you are in one of your peak earning years. Why not just make a plan to sock the windfall away in a low risk vehicle, and then plan to revisit your financial situation 2 years after both spouses retire?

By waiting 2 years, your AGI and tax rate will have presumably dropped, so you will be in a better position to lose the mortgage interest expense deduction. But more importantly, in those 2 years you’ll have learned how much you’re ACTUALLY spending per year, vs. how much you PLANNED to spend. In many cases, the numbers are quite different. But it’s your actual spending that should drive the question of whether it makes more sense to pay off your mortgage early.

6

I’m in the I-hate-to-owe-time-payments group. Mainly because a while back, when times got tough, I found that the amount of extra stress I went through every month, deciding what time payments to try to skip or what things I was paying for to let go of, wasn’t remotely worth the enjoyment I had got from having them.

I also wish to the powers that be (and obviously weren’t, or I wouldn’t have made the mistakes I did) that I too had been a spendthrift and investor from the time I was five. But that was too late a VERY long time ago.

At this point, I am far more likely to Just Say No to whatever purchases I get tempted by, just to avoid reducing my thin cushion. I have zero credit card balances, and buy only used cars, for cash. Had I not had a severely handicapped child, I would have paid off my mortgage by now, and be looking for tax-deductible investments.

The number ONE thing I consider to rule everything else about this, is avoiding stress. Because stress is the one thing that will a) make my life most miserable as I am living it, and b) will shorten it considerably.

7

This is debatable.

3.875% even let’s assume itemized deductible at a 25% marginal rate, so ~2.9% after tax looks low by historical standards of returns. But a) safe bond rates you can invest in are now also much lower than historically and b) we only know what stocks actually earn in hindsight, there’s a risk of very low or negative returns in stocks even for long periods (look at Japan for example). A 30 yr mortgage has an average life* of around 18 yrs. The 18yr point on the US treasury curve is around 2.45% before tax, say 20% tax (say the 25% included a state deduction, but treasury interest isn’t state taxable**), 1.96%. Funding safe bond purchases in taxable accounts with mortgage borrowing is a loser. If you assume some higher return for the investment, say stocks, it can be a winner…but you’re assuming, and have to be willing to take the risk your assumption is incorrect.

So the real answer is that it depends on your risk preference. It’s not a slam dunk, and an adviser who can’t gtee 2.9% after tax return (even before paying them :slight_smile: ) is not incompetent. They are telling you the hard truth of today’s market. But understandably a lot of them don’t want to tell you that. Although in theory you might think that telling people how low expected returns really are now with very expensive risk assets (stocks market, real estate etc) and very low safe bond yields would make them more eager to save, to make up for those low expected returns. In reality it often makes the investor defeatist and less willing to save. They’d rather hear that 2.9% after tax is a pittance compared to what they ‘should’ earn on a balanced portfolio after tax, but it isn’t.

Note, this doesn’t make it a dumb idea to have a mortgage you could pay off and instead channel the money to more investments (as long as not safe bonds in taxable accounts funded by a mortgage, which is an outright mistake). It again depends how much risk you want to take. Assuming in all cases there’s the standard several months to year+, depending one’s job security, emergency reserve put away in safe investments.

*consider when each portion of the principal is paid back and average it out, a standard concept. Only the last little bit is paid back after 30 yrs so comparing a 30yr mortgage rate to a 30yr bond yield in an up sloping yield curve is too optimistic.
**and we could go further into the weeds in various directions about tax. For example if the money used to pay down the mortgage was diverted from a 401k contribution that’s probably a bad idea, since those investment returns aren’t taxed for decades (for a young person) and all the more if there’s an employer match you’re simply leaving on the table by not contributing yourself. Or the person’s marginal tax rates state or federal could be different. But the point is it doesn’t necessarily make sense depending the person’s situation and risk appetite.

8

Financial decisions and strategies that are perfectly reasonable, even savvy, for wealthy people do not usually translate well for poor folk. Variable rate mortgages were the classic example, they were initially devised for people who could pay cash for a home, but didn’t want to tie money up. If interest rates moved the wrong way, they just cut a check and pay off the loan. Poor folk, working people can’t do that. A similar situation with cars. Wealthy people can write a check, an expensive car is like buying a pair of shoes from an economic standpoint. It doesn’t register on their budget.

Poor people borrow money at high rates of interest to “buy” a depreciating asset, and usually run into trouble when it’s all added up - insurance, maintenance and repairs.

9

Consider what will happen in the future.

If you buy a car, its value will depreciate.
If you buy a house, it will increase in value.

If you borrow money from a bank, you will pay less interest than borrowing on a credit card.
If you can afford to wait for your purchase and save up, you pay no interest.

10

Eh, monetary inflation and FED jiggery-pokery has a lot to do with homes “increasing” in value. And then the government feels entitled to a hefty cut of the nominal gains via taxes. And homes require lots of expenses to maintain, they “wear out” more or less, like anything else. They tend to be a good investment, but it isn’t for everyone.

11

Back to the OP’s car examples I say this

This.

It happens I just bought a car last month. And checked with my finance guy on the “pay cash or finance?” question. I told him my car loan APR was 2.99%. He said I’d be an idiot to pay cash.

But, ref Common Tater’s fine point about how some decisions don’t scale well, I can also choose to write a check to zero the loan balance any day of the week. Clearly the OP’s hypothetical couple talking about buying a car equal to 80% of their net worth are doing it wrong. As I would be if I bought a car equal to 80% of my net worth.
I thought it was telling that the various scenarios built towards “What best to do with a windfall?”

Windfalls often get misspent because although a dollar truly is just a dollar and they’re all absolutely equal and absolutely interchangeable, people’s emotional reaction to spending a dollar they had to earn and save is very different from their emotional reaction to spending a dollar they found on the street.

In general, the instant emotion gets into a decision involving money, dumb stuff happens.

12

Re the just previous post and I didn’t see it specifically dealt with prior. Those two scenario’s are exactly the same. If one would react to them differently then spurious emotional considerations are influencing the decision and really all bets are off on any analytical analysis.

For some the key question is ‘how can it be sold to them (get to them to sell it to themselves) in the way least likely to result in frittering away money they’ll eventually need in retirement’. And this is the reason so many people are full of advice from inventive personal finance guru’s which doesn’t really make sense assuming the consumer/investor is rational, but can make sense for the practical prime directive of preventing people spending themselves into old age poverty, which millions of people in the US (not necessarily limited to, but that’s where it will result in me having to pay more taxes to bail them out) who aren’t poor now are heading themselves toward.

Before I commented on scenario #4: it’s not obvious one should or should not pay down a mortgage with newly acquired money. It depends on risk preference. If you invest risklessly with the proceeds of a mortgage, that’s a loser, see above. If you take risk it can be a winner… but you take risk: the stock market isn’t ‘gteed’ to do anything, ever (again some people would never take stock risk unless someone convinced them it wasn’t actually a risk, so a lot of people have been convinced: ‘you’ll always come out ahead in the stock market in the long run’, but there are examples of countries where that hasn’t been true over quite long periods. You’ll probably make more after tax than the after tax cost of a 3.875% 30yr mortgage over 18 yrs, but there’s no gtee and it’s not a tiny chance you won’t).

  1. $25k is only enough reserve for somebody at a quite low spending level or a job that’s much harder to lose than the average job, or 1/2 income would be OK for a couple, but if that were so they’d probably have more saved. But it could be, depending on the person/couple.

2 and 3: probably can’t afford a new car, though again without a complete description of circumstances impossible to say for sure.

13

Investment models normally indicate that a realist LONG-TERM return on a well-balanced portfolio is 6-8%, but, yes, of course future returns are never guaranteed.

However, note that I said that if you’re not exceeding 3.875% RIGHT NOW, you should get a new advisor, because the stock market has been soaring since Trump took office. (S&P is up 9% and NASDAQ is up 15%.)

That being said, while most people are in “protection” mode in their 60s, it’s hard to know what’s good advice for people who have very little retirement savings because they’ve missed 3 decades of growth. Invest now and you may experience a bubble and have no time to recover. Stick it in your mattress and you may miss a really good rally (that doesn’t seem to be shaking loose, even though the press is really skewering Trump.)

14

Obviously I don’t know enough about money management to craft scenarios well, either, but they’re not representative of my reality.

We’ve been working with a financial advisor to make sure we have readily available cash as well as investments for future income and we’re confident in our decisions. At this stage of our lives, our only debt is the mortgage, and it’s got 14 more years to run, after a refi to a 20-year note.

Our plan for replacing our car when necessary has been to make “car payments” to savings so when the time comes, we can just right a check. That’s separate from our other savings, to avoid putting ourselves in a financial pinch. To me, it makes more sense to buy the car outright than to deal with monthly payments, but maybe I’m missing something.

Longer range, assuming my mother doesn’t face a catastrophic financial situation, I could inherit enough to pay off the mortgage. If and when that happens, we’ll talk to our money guy and decide what’s the smartest approach for us. So really, my questions are an attempt to learn something I may not have considered.

FWIW, I retired but went back to work out of boredom, and I’m maxing out the 401k. I feel like I’m working for future fun money.

15
  1. Again on ‘balanced’ part if somebody is going to borrow $100k at the mortgage rate (let’s just say) and invest in one common traditional definition of ‘balanced’, 60% stock/40% bond (of course not the only definition), the part where you borrow $40k to buy $40k safe bonds doesn’t make sense. The part where you borrow $60k to invest in $60k of stocks makes sense if that’s one’s risk preference. I personally would put the expected return of today’s loftily valued US stock market no more than 6-8%, so a 60/40 (2%-ish bonds) more like 4.5-5.5%, expected ie the presumed center of gravity of a huge potential variance in the long run, not ‘kinda that’s what it will be in the long run minus some absolute gtee’. We have no idea what it will be. I have a pretty high % of investment in stocks (less then 60% because I also invest in real estate which is also risky), but IME there’s a bias toward optimism from advisers (and their models) because if they didn’t do that, they would have too much trouble getting naive investors off the dime to do anything. People want to hear it will be OK.

Again the bond v stock thing IMO is important when it comes to (at the margin) financing asset investment with a mortgage. Almost always better to pay down the mortgage with whatever proportion of the ‘balance’ you would have put in safe bonds (again assuming sufficient emergency reserve to begin with). Financing a stock position with a mortgage is defensible but not obvious.

  1. If you mean “up to now” sure, but up to now means nothing for the future, the perennial problem of investing in risk assets.

  2. I agree this is a common dilemma, whether somebody should take more risk now because they didn’t save enough (or take enough risk, definitely possible also) in the past, or take less risk now because they have less margin for error. No easy answer. One surely wrong way to approach it though is viewing in terms of one’s politics or even what one believes is a neutral take on the political world. Whatever Trump (as one example) means to me or the market, there’s no reason to think I have a better insight into how that will affect future asset prices than what the market already reflects.

16

I leased a car even though I had the money to buy a car. The reason was that I thought I could get a better return using that money than I could save by paying cash for a car.

I have a friend not investing money into a retirement account for the same reasons.

Crunch some numbers. What will give you a better rate of return? Paying off a 4% loan will give you less than a 4% return on your money (because the interest tax deduction lowers the interest you actually pay.) Can you do better than that?

Some people are risk adverse or they don’t want to spend time investing or starting a business venture. If that’s you, then paying off the mortgage is the way to go.

17

The interest tax deduction only comes in to play if your total deductible expenses are more than the standard deduction. We’ve been homeowners for over 25 years and in only one year did it pay for us to itemize (the year we adopted our two children). Less than half of US taxpayers have enough deductions for it to pay to itemize.

18

You’re 100% right. But it’s actually even worse than that.

For 2017 the standard deduction for married filing jointly is $12,700.

If for example you have $13,000 in mortgage interest (and no other schedule A stuff) you don’t actually reduce your taxes by $13,000 times your marginal tax rate. Instead you reduce your taxes by $300 times your marginal tax rate.

IOW, The first $12,700 of taxable interest is useless; you were going to get that deduction anyway. Only mortgage interest in excess of $13,000 is making a difference.

The above example was a little unrealistic. Because most people who can itemize at all *do *have some other Schedule A deductions. Which only rarely are enough to qualify on their own; most folks need a hefty dollop of mortgage interest to bump them over the 12,700 hump where the other deductions start to matter.

So consider for example a couple with $1,000 of charitable and other Schedule A deductions.

They can either have no mortgage, take the standard deduction of $12,700, and lose the ability to deduct the $1,000.

Or they can have the mortgage, take the $13,000 mortgage interest deduction, and take the $1,000 of other Schedule A deductions. The net result is they reduced their taxes by $1,300 times their marginal tax rate. That’s a savings of ballpark $450/yr.

Which is nice and all, but offsetting a $13K annual interest bill by $450 amounts to a pretty small effective interest rate change. Its the same as reducing a loan with a 4% headline APR to 3.85%.

19

Not if your state taxes are high enough. There are plenty of renters in DC itemizing off of income tax alone.

20

We avoid taking out a loan as much as possible; we paid cash for our last new car, for instance.* Our house was paid off over a decade ago.

Much as I hate to dip into savings, that’s what it’s there for, and it always costs less.

*Actually, we put it on a credit card, then paid off the card the next month. You wouldn’t believe how many points we got!