I’ve usually been conservative about taking on any debt – including what’s typically considered “good debt” like school loans – so many of my friends were surprised when I chose to finance my car and get Youi Car Insurance. Well, I write elsewhere on the blog about investing. Leveraging your debt can be a great way to shore up more money for investing, and if the rate of return you receive is greater than the rate of a loan, you can come out ahead with some savvy borrowing. Even if you have the money in your bank account to simply purchase your car, you may be better off taking a car loan and investing your savings.
Here’s an example:
You take out a car loan at 5% APR for $10k, with a 3 year payback. That means you’ll pay back $300 per month and your total interest payments over the course of the loan will be $790.
You take the $10k you would have used to buy your car and invest it. At an 8% rate of return, you’ll end up with a return of $2,597.12. Even when you subtract the interest expense from your car loan, you’ll have made more than $1800 over the course of three years – using the power of someone else’s money.
Of course, many people don’t have much of a choice when it comes to whether or not to finance their car, truck or motorcycle. The good news is that financing can be a good thing, even so, and you still have two important choices. You can take out a loan for a longer period of time, meaning smaller monthly payments; you’ll pay more in interest over the life of the loan, but that interest may be off-set by the advantage of having more cash on-hand to invest or simply to build up an emergency fund to avoid much more costly expenses. Or you can take out a loan with shorter terms and a higher monthly payment; as long as you make sure you can afford your monthly payments, you’ll quickly pay off your car. And then, since you’re used to doing without that bit of cash, you can simply roll over what you used to send to the loan company and send it to an investment account instead.
Try this loan repayment calculator to see for yourself how you could leverage debt to build wealth. It all depends on the interest rate available to you and the terms of the loan, but the knee-jerk reaction of many to avoid debt (a la Dave Ramsey) often closes the door on opportunities to build wealth, instead.
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This idea has been around for a long time, and although I comprehend the mentality, it has a simple flaw that effects most people. Namely, the feeling people get when they are in debt verses being debt free. Having 10 grand laying around and needing a car, my first reaction wouldn’t be to ask for a loan only to introduce risk (stress).
There are several assumptions that are always made with future calculations like this that predict certainty where there is none. Even Mr. Ramsey makes these assumptions.
1. The assumption that you will continue to earn interest well above the loan interest.
2. The assumption that “Murphy” won’t visit. And, of course, by Murphy I mean the emergencies that show up to put a wrench in the best laid plans.
Good point Roberto. In today’s ultra low interest rate environment, taking on a 4-5% loan to invest the money instead might not be as good of an idea as it’s been in the past.