Most personal finance pundits will tell you that if a purchase does not produce income and depreciates, it's bad debt. They'll also tell you that you should avoid bad debt wherever possible, buying things like cars up front with cash. At first glance it sounds like great advice - by never going into debt, you completely rule out the possibility of ever being underwater. And to be honest, in most cases it is good advice, specifically for the financially inexperienced or those who have trouble managing debt.
However, as an investor this logic seems to be at odds with the time value of money and the opportunity cost of your money. To better understand the total financial picture associated with purchasing a liability, let's build and analyze some scenarios to explore just what the difference is. Here are our assumptions for purchasing a car:
- You want to buy a car that costs $40k
- The car will depreciate at a rate of 15% per year
- Homes in your area and rental rates each appreciate at 2% per year
- You can get a 5-year car loan with no down payment for 3% APR
- You can get a 30-year mortgage on a 200k property with 20% down payment for 5% APR
- You can reasonably expect 10% cash-on-cash return from 20% down on a $200k property with the seller to carry closing costs
Financing vs. cash purchasing is not necessarily as straightforward of a calculation as you might think. As an investor, you should be aware that every purchase carries with it an opportunity cost - if you decide to purchase the car outright, that's $40k you don't have available to invest. Therefore, lets look at it as if each decision is a set of two investments (one for the car, and one for the property), each with independent cash flow and equity:
In Scenario 1, the car is bought for all cash, leaving no money left to invest in property. In Scenario 2, the car is totally financed, and the $40k is instead used as a down payment on a $200K property with a 7.2% cap rate. Over the course of 5 years, by choosing to purchase this car for cash instead of financing it, you're paying almost 80% more (31k in this example) for your vehicle in opportunity costs! Not to mention after the car loan is paid off, you now have a property that is cash flowing around $4.5k per year.
I'll admit that when I ran these numbers, I was pretty surprised at just how much money can be saved by being cognizant of the opportunity costs, even with conservative numbers for investment returns. However, it's important to note that the reason most personal finance gurus recommend paying cash is because this strategy involves significant levering. You're essentially going into debt on a car just to allow you to then go even further into debt on a property.
So how do you know when it's a good idea to finance big purchases like a car and when to pay cash? If most or all of the following apply, you might want to seriously consider financing that next big depreciating purchase:
- You have a high tolerance for risk and are able to take on significant leverage. In the above scenario, the debt service for both the car and property in the second scenario was around $1800/mo. If you don't have a plan in place for how you're going to cover this in the event of prolonged vacancy or some disaster, you're setting yourself up for financial ruin.
- Your liability loan has a lower rates than your property loan. If you're able to score an auto/personal/HELOC loan for significantly less APR than a property loan, this might be a good way to take advantage of the difference. Don't think you can rationalize paying credit card APRs with this strategy and end up ahead.
- You can get significantly and consistently better returns from your investments than you will lose through depreciation. If you don't plan on investing with your saved up funds, have no saved up funds, haven't taken the dive on your first investment yet, or think you're going to work this by investing in mutual funds, you might want to reconsider.
- You actually need to buy a liability. The first question you should be asking yourself when you're thinking about buying a liability like a new car, boat, etc. is whether or not you actually need to buy it. At the end of the day it's still a liability that will lose you money over the long term, intelligently financing it is just a means to mitigate losses.
- You've actually run your numbers. Don't just assume that because you get good returns on your investments that this is always a good idea for you. Like every other investment, run your numbers for your opportunity costs so you can make an informed investment decision.
When it comes to making large purchases, it's important to consider the whole financial picture. We hear so much about good debt and bad debt from the financial gurus, but that's just a simplified picture. In reality there is no good debt or bad debt - there's only cash-on-hand, debt, and the opportunity costs and risks of trading between those two. Every purchase you make is an investment decision, whether you think of it that way or not. Taking the time out to consider your opportunity costs and risk tolerance for large purchases can save (or make) you a significant amount of money in the long run.
Agree? Think I'm crazy? Let's hear it!
The first thing that comes to my mind is the fact that cars don't depreciate at a constant rate. Your going to have heavy depreciation the first year or two, and almost none after year five or so. So if you get into trouble after six months, it's a different conversation than an extended vacancy in year 5, but that's where your point about risk tolerance comes in.
The thing I Iike about used cars is the opportunity to find bargains. Just like houses, you can find motivated sellers of cars. We made a profit last year selling a car my wife drove for 8 years, and the 10 year old van we replaced it with is up (according to Blue Book) almost 20% over what we paid. But I guess all that proves is that opportunities are everywhere if you understand your market.
I am a PF junkie and this is exactly how I justified buying my new Subaru. I was driving a used car that was a gas hog, starting to break and was a constant worry. The cost of the car + the savings of maintenance and gas + keeping get it for 10 years = I can focus on making money. The cost and 2.99% Financing is pretty close to chasing a good deal on a used car every 3 or 4 years. I drive a lot of miles, so I also had to factor in a car that can handle the miles. This car is a tool to make my job easier. I have not reached - anywhere close - to letting my business buy me a luxury car so this is how I handled and justified my new car purchase.
Brendan, you have the basic concept, well done, but as Johnny points out, a bit flawed, but the principles are there. "Buying a liability" sounds like guru talk, you buy assets, they are appreciating or depreciating assets, not liabilities. You tale on a liability with debt.
What you called your opportunity cost appears to be the sum lost by not taking the other investment, it's really the difference of the benefits received. A new car won't generate cash flow, agreed, but is there any value to it? Let's put ego aside at the stop light. If you are rather new, it may influence others to some degree that you are successful enough to swing a new car, you're not a total dead beat (LOL), I see through such things, but others may look to your stature and it may help in obtaining business, a more favorable impression.
BTW, I'm not advocating buying a new car! Just pointing out intrinsic values may play in opportunity costs.
Try this example: You go to Zales and buy a simple engagement ring for $2000, take it home. You get cold feet and it takes over a year to pop the question......she says no, love you, but no.
Now what, you financed the ring and take it to a pawn shop, the guy will give you $600 for it! Now, that is bad debt!
Moral of that example, from a personal finance side, always propose using a cigar wrapper, if she says yes, it's about you, then go together to pick out your ring! LOL :)
Bill Gulley, General Real Estate Academy | https://generalrealestateacademy.com
I think your analysis is ok, but I think their point was don't buy a depreciating asset rather than don't finance one.
@Johnny Mack - I'll agree 100% - I'm a used car guy through and through! But this applies just as well to used cars - or anything really. Even if your car appreciated, you could still run this analysis and find that the cash flow opportunity cost I wrote this up as a sort of mental exercise, to be aware that while buying things with cash might be simpler, it's not always so straightforward as to be the "best" route for making a large purchase.
@Raven Dorminey - Did you end up immediately investing the money you saved up front by financing instead of paying cash?
Kiyosaki mentions in Rich Dad Poor Dad that his wife wanted a new Benz so he bought real estate and used the cash flow to make the car payment. You say they are wrong but Kiyosaki recommends to use investments to pay for your bad debt if you must have bad debt. I do not follow Ramsey so I can not speak for him. If you asked Kiyosaki to choose between buying a car cash or using leverage and investing the cash I guarantee he would recommend the latter. The main point from Rich dad Poor dad is to have your money work for you. Buying good debt to pay for bad debt is exactly that. IMO your strategy is backwards. Instead of buying the car then investing the money, you should invest the money and create passive income that will allow you to pay for the new car note.
@Bill Gulley - You're right on the depreciating assets vs liabilities - I actually had it written up as depreciating assets and then confused myself on the lingo and changed it all right before posting because "depreciating asset" sounded pretty oxymoronic to me ;). And I agree that there are often intrinsic values built into these large purchases that don't appear very evident in paper analysis. But doing this type of analysis presumes you're looking to buy the same depreciating asset, financed or not, so those intrinsic values will be equal on both sides of your analysis.
Also regarding your ring example, that certainly would suck! But that's an example of how an asset has now depreciated so quickly that it would be even more prudent to have financed it and used that money instead for investment (though in your example, it might be hard to invest with just $2000.) The depreciation hit is going to happen whether it's financed or not, it's just a matter of whether you're going to use other people's money to keep your cash-on-hand liquid and ready to invest elsewhere.
@Frank B. - There are certain times, like with a car, where you might need to purchase a depreciating asset. I agree that when avoidable, you shouldn't purchase things that are going to lose you money in the long haul. But Dave Ramsey in particular makes it clear that if you're going to purchase a depreciating asset, you should purchase it with cash up front. Granted his target audience for this advice is largely those who have trouble managing their finances, but a lot of investors with strong financial management skills might be better off performing their own analysis to arrive at a decision to finance or not.
@Brendan Morin Go reread Kiyosaki, you've clearly not understood his point of view.
His stance would be to use the money you would having used to buy a car to buy an investment to pay for the car: (He that exact example in Rich Dad Poor Dad.)
Ramsey's point of view is that personal finance is part mental/psycological, so using math to proove him wrong is usesless.(How convenient: he setup a system in which he can't be proved wrong) He admits the math proves him wrong, but maintaims his viewpoint is correct.
I gave away my copy of Rich Dad so I was working from memory regarding Kiyosaki, but I'll admit I may have misunderstood him there. The rest of his philosophy resonated with me pretty deeply so that makes sense that the part I found discordant probably just arose from me misunderstanding his intent. So more or less my original post was philosophically in line with Kiyosaki.
That said, I'll stand by my comment about Ramsey. Personal finance may be largely mental or psychological for many but for me I always try to let the numbers speak first.
The idea of buying a $40k vehicle whose worth drops 'like a rock' early in your career and expecting to get somewhere in RE is ludicrous. This isn't a leverage or interest rate discussion. This is a why would you purchase something that has such a stupidly negative ROI discussion. Because 'I wanted it' they will say. Children do what feels good. Adults devise a plan and follow it.
The safe, reliable car argument doesn't fly either. One of my tenants has a sweet Dodge Challenger that just died. Left him at the grocery store. Now he has a car payment and a $600 ignition repair bill. Another tenant for life.
Please speak to how the new Subaru or $40k car has worked out in regards to your investing @Raven Dorminey and @Brendan Morin ? Has it helped you purchase your 10th rental or flip? Your first? Where are we? 'Feeling' better about your large purchase may keep us in mediocrity. Because I've never paid a lot for anything with a motor I can buy my 35th rental next week if I choose to. Not saying I'm better than anyone else. I just have choices now buying a nice car early on wouldn't have afforded me.
There are folks on BP with very nice cars. Boats and toys, too. The ones I'm thinking of can afford them and have earned them. Early on it would have been an anchor. I hope some of them share as well. Thanks!
reality is there are very few 40k rental homes you can buy today in America that will appreciate like you charted... and they are in no way liquid for usually what you have in them.. to sell them generally generates a cash loss the only way your 40k rental has a TRUE cash value as you charted is if the rents rise so that investors can back into the 2% rules or there abouts...
NOw with higher end assets or stronger SFR areas Like were you live.. this appreciation scale may work.. but in most low end areas ( were you can buy sub 50k homes) there just is no appreciation and your model is just wishful thinking.
You can run numbers all day long but you can never truly calculate risk. The broader point (especially from Ramsey) is that debt can turn a smaller risk into a bigger one. In real life, it becomes a gut-check, educated guess situation. If you can calculate a range of possibilities and figure out how you would handle the absolute worst case scenario, and that's not too bad for you, then you go for it.
If I went on the Bogleheads forum and told those guys that my IRA was 100% stock, most of them would think I was taking on too much risk by being out of bonds. But I know my timeline, I know the historical averages, and I know the worst case scenario. The risk that I reasonably perceive from that based on 90 years of data is less than the risk I perceive from the lower returns in bonds. But I wouldn't finance a car to free up investment capital because I perceive that risk differently. YMMV.
On a side note, I have young kids. I would feel stupid vacuuming crackers and shampooing Play-Doh out of the carpet on a brand new car, but when they're grown it'll be game-on.
@Steve Vaughan - I couldn't agree more. Honestly, I'm not the type of guy who buys a 40k car or a boat. I just devised this scenario to say if you're absolutely going to do it, choosing to purchase via cash or via financing is not as straightforward as it seems. Honestly, this post is 90% me playing devil's advocate. I live simplistically - I save around 70% of my take home income so I can reinvest it, and I don't do that by taking on 40k car or boat payments. Some day when I have enough to justify a large purchase like that maybe I'll take the dive. But for now it's simplicity for me.
@Jay Hinrichs - I apologize if I wasn't more clear, I'm not talking about purchasing 40k homes, I'm talking about purchasing 200k homes with a 40k down payment. Though even assuming the home doesn't appreciate but does cash flow, you still would end up ahead compared to an outright cash purhcase of a car.
got it... I missed that part.... I drive a Hyundai...
I also really think this whole discussion depends on what you actually do for a living.. if your W2 and your income is basically the same year in and year out then you HAVE to really budget hard.
If your self employed and one month make 10k the next 40k one year you make 150k the next 500k.... you can be a little more casual about debt ... Cars are a necessity for most.. unless you live in a city with a fabulous transit system. or again have a W2 job that takes you to the exact same place each day and you can do that with easy public transport.
What is really not good is running up credit card debt for ANY type of purchase.. If your not paying your cards off monthly then your taking on very poor debt in my mind.
But us folks in Real Estate a dependable vehicle is a must.. especially early in my career when I drove over 40k miles a year and was selling ranch land in Northern CA... many of my listings were 10 to 30 miles back into the National forest.. not a place to be bringing your used car.. I always had brand new cars... and still buy new every 2 years... I have not paid for anything but an oil change in all these years. I would not even know how to buy tires LOL... But for the full time RE broker investor that is a business tool and write off along with in the day a TAX credit.. so have to look at the whole picture.. Just like airplanes up until last year there was all sorts of huge tax benefits for buying airplanes.. you got section 179 bonus depreciation.. there is a reason small to mid size corps have them and of course big corps.. as they pay for them selves or nearly so. Not to mention increase in productivty that is a little Harder to guage
Steve will get this one... In one day a few years back.. I had 4 HML requests.. One in Tillamook Oregon... One in Hood River Oregon one in Wenatchee WA. and one in Omak WA...
I left my hanger in Aurora Oregon at 8 am.. was in Tillamook at 8:30 ( its a 2 hour drive) 45 minutes on the ground looked at loan and passed... 40 minute flight to Hood river looked at loan and made the loan Tillamook to Hood River 3.5 hour drive.. it now about 11am.. 1 hour hood River to East Wenatchee ( hood River to Wenatchee 3 plus hours drive) passed on loan... 30 mintues Wenatchee to Omak made the loan about 2 hour drive. It would have taken me 3 days to drive all of that... once I left Omak at about 3:30 I was home base at about 6 and home in time for dinner. Made two loans.. cost to run airplane about 2k that day... fun off the charts... made about 10k in fee's.... :) so its all relative to your job and lifestyle.
@Jay Hinrichs - nice! Now that's putting your airplane to use! A toy with an ROI. Love it!
the best part is when I bought it in 04 ( a peak earning year for me) the tax code allowed me to write off 90% of purchase price year one>>> saved me about 150k in income tax I would have paid to uncle sam that year... Now recapture is a Beoch for sure some day.
a lot of intrinsic value being a pilot in the NW as you know flying the cascades and the Oregon WA coast is pretty special... :)
@Steve Vaughan I "feel" just fine knowing that I financed my 25k car at 2.99% and I have a dependable car to get me to work and my investment houses. I live in the country so I am 45 minutes from town and my rental house. I have always driven used cars and pushed my fair share of cars off the road when they stalled out. And in 10 years when my Subaru has 250k miles on it and smells like blood, sweat and tears I am sure I will have gotten my money's worth.
My justification is this: If I Pay Cash for a $7,000 car every 3 years - I drive a lot and have worn out 2 used cars in last 6 years... Then I have 21k tied up in cars. If I ever need to use any of that 21k for repairs on rental, down payment or closing costs on an investment house, I can't even begin to borrow that money at 2.99%
I believe keeping the money liquid for investments is better than paying cash for a new car or multiple used cars. The best things about a new car are better interest rates, warranty for a while, and you can keep it maintained. If you keep it until it is worthless you get all your money's worth. I chose a Subaru because it has the best maintenance reviews and it can handle high miles.
So if there is something that you can finance for a low interest rate, do it!
I also have financed a roof for my rental house for 5.99% interest on my Lowes Card. This way I came up with none of the money for the roof and the cash flow pays the payments. - - Leverage isn't always a bad thing. Debt is only bad if you have no plan to pay it back.
Originally posted by @Brendan Morin :
Agree? Think I'm crazy? Let's hear it!
I actually are that a car should be bought with finance. I find it odd that people buy a depreciating asset with taxed money,
But, there are many different things to consider, as it's not a financial desicion. Finance is absolutely nothing these days.
Buying a car should revolve around the impression you want to set when someone new meets you.
If you turn up in an old car, you look poor, no matter how much "I spent $5k on this and I own it outright", that will not balance out the shock of seeing you in some old Ford when you are presenting yourself as a hotshot investor. No matter how prudent you are, the car makes you look bad.
If you are young, buy a small new hatch; that looks prudent. If you are old, do not buy a small new hatch; that makes you look cheap and broke.
I drive have two pickups, a Ranger that is my workshop that I roll around in most days, and a late model F250 white work truck for when I'm seeing contractors. The F250 means business, it's what people expect you to be in. And more than that, when you start running a big pickup with a full bed, it shows that this is your business. And the quote you get from contractors reflects that. Turn up in a fancy BMW in a suit, and expect your quote to reflect that as well. I know investors that are getting shafted because of their car and how they present themselves.
My tenants see the Ranger. My contractors see the F250. I know landlords that run two cars, an old battered up a Focus for tenants, a 6 month old E class Mercedes for personal.
So choosing a car is about perception. Until..... Until you reach the point that say Jay has got to. He doesn't need to impress anyone, his reputation does that for him. But we're not all quite there yet.
A lesson I learned years and years ago is that successful people you deal with want to see you being successful and the car is the easiest way to show that.
The flip side of buying in cash is if you are wealthy, and you can drop $100k on a car and be done with it.
Originally posted by :
got it... I missed that part.... I drive a Hyundai...
I drive a 18K hyundai (now depreciated to around 10k) too. just trying to figure out how to make enough cash flow to buy a Tesla (modern benz).
I'm waiting patiently for the next recession so that I can gobble up discounted properties to hedge against risk, higher appreciation potential, and obviously higher cash flow!
Yes! I want to do the same! My Subaru hatch back will be my work car and I will drive my Tesla on my day off!
I think we all agree that we work hard and we want to make sure our money is all working for us no matter what we spend it on. I just want to make sure I enjoy a little bit of it. Otherwise, what is the point? I know plenty of rich people who have tons of money and all they do is sit around worrying about it.
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