Argument for taking loan for purchasing instead of using available cash(If total amount is available in cash)

[claudiaspollen]

Disclailmer: This is not financial advice. Iam not a financial advisor. Do your own research

If you have cash to purchase say a car , it is better to purchase it on a loan and invest the amount suitably because the CAGR return needed to breakeven with interest cost is way lower than the bank interest rate. Here's a calculation demonstrating the same:

+
A
B
C
D
E
F

1
cost of purchase
loan interest rate
total interest expense(7 year tenure)
cagr return to break even(at 30% tax )
cagr return to break even(at 10% tax )


2
100000
8
30,924
5.36
4.3


3
100000
9
35,148
5.98
4.82


4
100000
10
39,450
6.59
5.33


5
100000
11
43,828
7.19
5.83

[sup]Table[/sup] [sup]formatting[/sup] [sup]brought[/sup] [sup]to[/sup] [sup]you[/sup] [sup]by[/sup] [sup]ExcelToReddit[/sup]

The cagr on investment required to breakeven on a 10% interest loan is 5.33% if the tax is 10% like on equity investments or 6.59% if the tax rate is 30% like on Fixed deposits .

The calculation:

• The total interest expense on column C is sourced from 'EMI calculator dot net' .
• how much amount is required to break even (for 30% tax bracket)= Total interest expense/(1-0.3)
• CAGR required to break even(Column D) . I sourced from 'cagrcalculator dot net' .

You can do your own calculations and check it for yourself.

By this reasoning I have bought my car(in 2018) on Loan even when I had cash .

Edit: I changed my position . Here's is the final calculation:

If you have 1,00,000 at hand and want to buy 'X' there are two options

• Instead of buying 'X' by cash you took a loan at 10% interest rate for 7 years and invested the cash in a index fund at 8% XIRR .At the end of 7 years the total cash outgo Rs 2,39,450(total EMI=1,39,450+ invested amount=1,00,000) and your final invested value is Rs 1,71,382
• If you bought 'X' by cash and invested the emi's which you would have given in point 1 as SIP
  
  into same index fund at 8% XIRR. At the end of 7 years the total cash out go is Rs
  
  2,39,450(Cash purchase of X=1,00,00 +total SIP=1,39,450) and final invested value of Rs
  
  1,89,000

So option 2 is better in terms of returns. So I changed my Mind

 

[huckfinn151]

@claudiaspollen When you take a loan, you are paying EMI every month.
So you should calculate what would happen if you had paid upfront, and then invested that money you saved by not having to pay emi in a sip with return of say FD rates.

 

[denisovic]

@huckfinn151 Wouldn't it still be less than investing the upfront money he has at the same FD rates?

 

[huckfinn151]

@denisovic Not really, coz he is paying 8% interest on the car loan.

 

[claudiaspollen]

@huckfinn151 You are right I changed my mind. Please see the edit

 

[johnpereless]

@claudiaspollen Tldr; take a loan only if the effective interest rate is less than post tax returns from other investments. Isn't that common knowledge ?

 

[kenm]

@johnpereless Username doesn't check out.

You're right. If your effective return on investment > loan interest rates, it's good to take a loan instead of paying cash up front.

What most calculations miss out is the sequence of returns. They assume a constant 10% returns from index funds which is hardly going to be the case.

 

[johnpereless]

@kenm Yeah that's true. For loan vs pay calculations I usually assume 2-3% less returns for lumpsum vs sip to account for sequence of returns.

 

[terranova]

@claudiaspollen A car purchase might not be a tax deduction for everyone. So you don’t get any tax shield

 

[claudiaspollen]

@terranova A Tax deduction is not required! I think you misunderstood the post . The tax brackets are for how calculating how much more returns you need to break even in the particular tax bracket.

For example: If you take a loan of Rs 1,00,000 at 10% interest The total interest at the end of 7 years is Rs 39,450 So you need a CAGR of 4.86% but if you are in a 30% tax bracket you have to earn a higher return to compensate for the tax deduction which comes to 5.33% which gives you a final investment value gain of 43,835. If you deduct 30% tax you'll get Rs 39,450 which is the amount of return you need to break even.

 

[christad]

@claudiaspollen I'm not in the mood to do the math but I'll go by my grandfather's advice before he passed on to the forever good beyond "Son, loans are the only things in life that are dirt easy to take and painfully difficult to repay". I'd only ever consider a loan for when I needed to cover the difference period. Not when I had the whole damn money available readily. What good purpose would it do to take a burden willingly when you could easily get the benefit of your expenditure right away?

 

[resjudicata]

@claudiaspollen I believe you are assuming that the 1 lac capital is not being used to pay the emi. If you count the full emi amount being deducted from the capital of 1lac then your investment rates of return will have to be higher than the borrowing cost for any arbitrage to work. Sorry to say but this calculation is flawed and doesn't make much sense

 

[x_miar_x]

@claudiaspollen Sorry, to say the crux of the proposal is flawed. You cannot arbitrage at a rate lower than your borrowing cost. If you earn 6.6% on 100k and make an EMI of 1,660 from it at 10%, you will run out of money in 6 years

year
withdrawals
interest
balance


1,00,000

1
19,920
6,076.66
86,156.66

2
19,920
5,134.86
71,371.52

3
19,920
4,128.95
55,580.47

4
19,920
3,054.63
38,715.1

5
19,920
1,907.2
20,702.3

6
19,920
681.75
1,464.05

7
1,464.05
0

 

[delightintheway]

@claudiaspollen Many sides to this.

I make more in the market than car loans, and sometimes even personal loans. So loans are generally better for me, but only marginally.

I do have a secure job, and my skills make sure that I would never really lack a steady income.

Loans make me want to work hard, as I can get the things I want as soon as I can, instead of worrying about saving up.

Majority of my expenses are recreational/ voluntary, which can be cut anytime I'm in need of cash.

If at any point I desperately need money to pay off debt, I have more than 10 years expenses saved up.

 

[nol]

@claudiaspollen If your original assumption was true - you could just keep taking personal loans and making money by investing the money...

 

[claudiaspollen]

@nol Go on check the calculations for yourself and check if the assumption is correct. Please also see the final edit.

 

[nol]

@claudiaspollen No thanks - got better use of my time.

 

[resjudicata]

@claudiaspollen

The cagr on investment required to breakeven on a 10% interest loan is 5.33%

While your 5% may be right , Fundamental CONCEPTUAL error

To pay 10% interest, I need to earn 15% pre tax. 5% is actually the loss incurred due to availing the loan.

The borrowing method works only if you have to liquidate assets to raise cash. The capital gains tax can be deferred by using current cash flow to pay EMI and using a tax shield

Pontificate on how the error applies to your working or as Rohit with a big ego mentioned

Compare with a fd return for the same period (both post tax.. so a 8% fd returns 5.6% vs 8% car loan).

 

[claudiaspollen]

@resjudicata

To pay 10% interest, I need to earn 15% pre tax

No! The calculation is for post tax returns. As I have replied in other comment quoting

"For example: If you take a loan of Rs 1,00,000 at 10% interest The total interest at the end of 7 years is Rs 39,450 So you need a CAGR of 4.86% but if you are in a 30% tax bracket you have to earn a higher return to compensate for the tax deduction which comes to 5.33% which gives you a final investment value gain of 43,835. If you deduct 30% tax you'll get Rs 39,450 which is the amount of return you need to break even."

Could you explain more about your comment"The borrowing method works only if you have to liquidate assets to raise cash. The capital gains tax can be deferred by using current cash flow to pay EMI and using a tax shield" ??

I am sorry If I came across pompous , I didn't mean to!

 

[resjudicata]

@claudiaspollen A fd rate of 8% will give you 146500 (30% tax) in 7 years vs a payout of 139450. At the end of 7 years you have a FD worth 1.46k

However if you use the FD in lieu of loan, you free up the EMI. At a FD rate of 7% & EMI of 1660, (a recurring deposit in ELI5 terms), it will be worth 1.65k at the end of 7 years.

And 1.65 > 1.46