For those who were raised in the Great Depression Era or raised by Great Depression Era parents, we sometimes have developed an aversion to borrowing money. Let us explore the benefits today of borrowing, versus paying outright for a large purchase (new home, second home, boat, vehicle, home improvements, or dare I mention, a very large tax bill owed this tax season!).
In the example of a new car purchase (you can apply this to all of the examples above in addition to others) your choices are basically to finance the purchase or pay in cash, which each have pros and cons. However, given the current low-interest rate environment, financing the purchase is the recommended option due to one major “pro”—you can keep more money invested in a properly diversified portfolio at BWFA!
Assuming you have good credit and there still exists low borrowing rates—as low as 0% for many vehicle purchases—you can stretch the payments of large purchases over several years or longer so that your money works for you in your investment portfolio over time and generally grows on average at a pace much higher than the low (or zero) interest rate costs you will pay on the loan.
What can you afford to pay in monthly loan payments?
- If you are retired, you often hear us recommend keeping your overall annual draw rate (the amount you take from investments for living expenses) at 4-5% of your total invested assets (approximately $50,000 for every $1 million invested). If your current withdrawal rate is less than 5%, and if your new loan repayments do not increase your withdrawal rate above 5%, then financing the purchase would likely be financially beneficial, especially over a long time horizon.
- If you are still working, conservative estimates suggest the total of all car/ boat payments stay below 10% of your net income (after taxes) —and the total debt payments (including mortgage and credit cards) are kept below 30% of gross income (before taxes).
Are there some drawbacks to financing? Maybe.
- Zero-interest financing— some businesses offer zero-interest loans, and if you make on-time payments, no interest or penalties will be applied. However, these zero-interest loans often have a “deferred interest clause” which means that even if you only miss one payment, you will be charged deferred interest, sometimes up to 30% or more!
- Insurance costs— you may be required to pay mortgage insurance when financing the purchase of a home, but in most cases if you make a down payment of 20% or more, then you can avoid this additional cost.
- Rate fluctuations— given the potential for continued gradual interest rate hikes, if you do not have a fixed rate loan, then in the future you may pay more in financing which could reduce the overall benefit of borrowing to make the purchase today. So, when possible, use a fixed rate loan in the current interest rate environment.
LENDING SOLUTIONS—BEYOND THE TRADITIONAL LOAN
In addition to “getting a loan from the bank”, BWFA offers unique collateralized lending options for those with eligible, invested assets managed by us. Ask your BWFA advisor for more details when contemplating your next large purchase (even if it is a large tax bill payment!).
Thad Ismart | CFP® | Senior Financial Planner | tismart@bwfa.com