4.99% loan - payoff or keep?

[catccc]

So I actually don't have this loan, but I am buying a car today and have an opportunity to take out a loan.  Yes, it's new car, no, this is not really a mustachian move.  Our 2005 toyota matrix with 267K miles needs too much (clutch & catalytic converter), used car prices are still crazy, and we have a history of hanging onto cars for the long haul.  So whether or not to get this car is not my question.

At any rate, or rather, at the available rate of 4.99%, we have a new 2023 hybrid rav4 coming our way (tonight).  We were going to pay cash for it, but at 4.99% and rates on the rise, cash earning over 5%, plus investments expected to return beyond that, I am rethinking not taking a loan. Other considerations include taxes (marginal $ earned taxed at 22% for federal, 3.07% for state, and 1% for local).  So from a straight up arbitrage standpoint, after taxes it means we are out a little if we are comparing to savings rates.  I could deploy cash into investments, instead, though.  (Why have I not already deployed this cash to investments?  bc we were going to buy a car.)

I've long been debt averse but we bought our first house in 2021 and that 2.75% interest rate is so tasty.  I'm thinking 4.99% might be reasonably palatable.  I figure if my expected rate of return goes down, I can just pay it off early, but if it goes up, yay for 4.99% interest, right?  Thoughts?

[secondcor521]

What is the term and approximate amount of the loan?

The way I see it, you're currently paying about 1.3% of the loan amount annually for the opportunity for arbitrage.  You're getting 5% on cash, which is taxable so you have to pay 22%+3.07%+1%=26.07% in taxes, netting you about 5% - (5% * 26.07%) = 3.7% after taxes, which you use to pay your 4.99% loan, so 3.7% - 4.99% = -1.3% cost.

What makes you think rates on cash are going up?  Most people (including me) think we're close to or at the top of the rate cycle.  I certainly doubt they would go up far enough and soon enough to turn that -1.3% cost annually into a profit over the life of the loan.

I wouldn't do it for the long term arbitrage.  I might consider doing something like this if it helps me avoid some sort of tax cliff that I might go over if I had to, say, sell investments and realize CG.  But you said you have the money in cash already, so this scenario doesn't really seem to apply to you.

Are there loan costs that are due even if you take and pay off the loan in a few months?  If these exist, that would make the deal even less palatable to me.

Even if it did work out, with a loan of maybe $30K and gaining a (SWAG guess->) point of arbitrage for three years, that's $900.  You probably have an easier and less risky way of gaining $900 over three years.  You're talking the equivalent of a McDonald's meal once a month.

[index]

Check what the difference is for insurance and origination costs of the loan. You will likely be required to have gap coverage which might push you further into the pay cash camp.

[Finances_With_Purpose]

Check what the difference is for insurance and origination costs of the loan. You will likely be required to have gap coverage which might push you further into the pay cash camp.

Spot on. 

This is a close one, but doesn't look that likely to be profitable.  After-tax, I think you lose here, especially considering insurance.  (You can plug in your tax rate on the interest income and see, then adjust the rate needed, but it's likely above 5.5%.) 

You also pay a financing fee/costs, I'm sure, which they're not telling you about until you closely read the final contract.  So another reason you're probably going to lose when it's relatively close.  (I have found that when things are pretty close, the hassle and hidden costs - especially when dealing with financing/car sales - make it unattractive.  Too many downsides.) 

I would just pay cash for the car. 

Only possible difference: dealerships push loans.  So maybe you take it for six months and then pay it back, but then you have to read all of the terms very closely to see how/if they're trying to screw you.  So, I just turn them down and pay cash, as I hate car-sales shenanigans. 

I don't think 5% debt is that attractive.  Below 4%, say 3.5%, is where it gets more interesting. 

[Radagast]

That's higher than the SEC yield on VWALX (Vanguard High Yield Tax Exempt Fund), so I'd tend toward paying it off if you have cash or bonds. After tax that's a better rate than any reasonably safe bond.

If you were to invest in stocks 4.99/0.85 (15% cap gains tax) = 5.87% tax equivalent stock return required to come out ahead. It's a gamble which comes out ahead, but stocks do better 4/7 in the mid-short term I guess. Typically much better or much worse hence the gamble.

Tending toward pay in cash.

[Dibbels81]

Thanks OP and others for crunching the numbers, as I'm facing a similar situation, with a non-mustachian but happy-wife, happy-life car purchase on the horizon. With some black friday finance deals coming around, would a 2.9% interest rate swing the arrow towards financing instead of cash purchase? Currently, the money earmarked towards the car is enjoying a 5.3% interest rate on Vanguard.

[Radagast]

Thanks OP and others for crunching the numbers, as I'm facing a similar situation, with a non-mustachian but happy-wife, happy-life car purchase on the horizon. With some black friday finance deals coming around, would a 2.9% interest rate swing the arrow towards financing instead of cash purchase? Currently, the money earmarked towards the car is enjoying a 5.3% interest rate on Vanguard.

I'd take a loan at that rate. After tax treasuries & CDs, as well as tax exempt bond funds, all offer higher return.

[Dicey]

Haha, I just wondered what the loan was for over on the DPOYM thread. Nevermind.

IMO, some differences are that the car loan isn't tax deductible (unless it's a second against your home, but I only skimmed your post), nor does a car typically increase in value. However, if your green soldiers continue to earn more than this rate, it's still worth considering.

That said, "Meh". If all your other ducks are all in a row, it's kind of a coin toss.

I am deliberately staying out of the "but do you really need a new car?" drama, because that's your call.

[secondcor521]

IMO, some differences are that the car loan isn't tax deductible (unless its a second

When is a second car loan tax deductible?  That would be news to me.

[Dicey]

IMO, some differences are that the car loan isn't tax deductible (unless its a second

When is a second car loan tax deductible?  That would be news to me.*

The question came from the DPOYM thread, so in this case, second "mortgage". I'll change my comment to make it crystal clear. God forbid I'd appear to be impartial about taking a second loan against the same car. Eeks!

*Of course that would be news to you. Car loans aren't tax deductible, which was exactly my point.

[Gronnie]

Check what the difference is for insurance and origination costs of the loan. You will likely be required to have gap coverage which might push you further into the pay cash camp.

I don't think I have ever been required to carry gap insurance, even when putting 0 down. Is that a new thing?

[secondcor521]

IMO, some differences are that the car loan isn't tax deductible (unless its a second

When is a second car loan tax deductible?  That would be news to me.*

The question came from the DPOYM thread, so in this case, second "mortgage". I'll change my comment to make it crystal clear. God forbid I'd appear to be impartial about taking a second loan against the same car. Eeks!

*Of course that would be news to you. Car loans aren't tax deductible, which was exactly my point.

Thanks for the clarification, I really appreciate it.

[Dicey]

IMO, some differences are that the car loan isn't tax deductible (unless its a second

When is a second car loan tax deductible?  That would be news to me.*

The question came from the DPOYM thread, so in this case, second "mortgage". I'll change my comment to make it crystal clear. God forbid I'd appear to be impartial about taking a second loan against the same car. Eeks!

*Of course that would be news to you. Car loans aren't tax deductible, which was exactly my point.

Thanks for the clarification, I really appreciate it.

Ha, I was just reading your response on another thread and thinking how much I appreciate you and your willingness to help others out here. The appreciation goes both ways, but you're smarter!

[secondcor521]

IMO, some differences are that the car loan isn't tax deductible (unless its a second

When is a second car loan tax deductible?  That would be news to me.*

The question came from the DPOYM thread, so in this case, second "mortgage". I'll change my comment to make it crystal clear. God forbid I'd appear to be impartial about taking a second loan against the same car. Eeks!

*Of course that would be news to you. Car loans aren't tax deductible, which was exactly my point.

Thanks for the clarification, I really appreciate it.

Ha, I was just reading your response on another thread and thinking how much I appreciate you and your willingness to help others out here. The appreciation goes both ways, but you're smarter!

Thanks for the very kind words! :)

[Dave1442397]

Check what the difference is for insurance and origination costs of the loan. You will likely be required to have gap coverage which might push you further into the pay cash camp.

I don't think I have ever been required to carry gap insurance, even when putting 0 down. Is that a new thing?

Some lenders require it, but it's usually optional.

It's something that should be researched before going to the dealership. We got a zero down 1.99% loan on our Toyota two years ago, and they offered gap insurance that was super expensive - at least $25/mo. I checked with my insurance company, and they offered gap insurance for around $30 for the entire life of the loan.

I only bothered getting it because we were doing a zero down loan, but as it turned out the car has always been worth more than the remaining loan amount anyway, due to new car supply chain issues.

[catccc]

Well, I took the loan.  No origination fees and I was able to decline gap coverage.  Moved savings into custodial accounts to mitigate taxes, so we are now in the mathematically advantageous zone!

[secondcor521]

Moved savings into custodial accounts to mitigate taxes, so we are now in the mathematically advantageous zone!

How does that work?  If it's custodial accounts for your kids, then that money is now their money and can't legally be used to pay back your car loan.  You'll have to use your own money for that:

The way I see it, you're currently paying about 1.3% of the loan amount annually for the opportunity for arbitrage.  You're getting 5% on cash, which is taxable so you have to pay 22%+3.07%+1%=26.07% in taxes, netting you about 5% - (5% * 26.07%) = 3.7% after taxes, which you use to pay your 4.99% loan, so 3.7% - 4.99% = -1.3% cost.

Unless your numbers in the OP are wrong, or I'm missing something, I think you're losing money.  Although only at a dollar a day or so, so you might not notice.

[catccc]

Moved savings into custodial accounts to mitigate taxes, so we are now in the mathematically advantageous zone!

How does that work?  If it's custodial accounts for your kids, then that money is now their money and can't legally be used to pay back your car loan.  You'll have to use your own money for that:

Yup, and that's fine.  We make regular contributions to custodial brokerage accounts and 529s for the kids out of our income, and instead our income will go to the loan and the cash in the custodial accounts will be for those contributions, therefore continuing to benefit the kids.

[secondcor521]

Moved savings into custodial accounts to mitigate taxes, so we are now in the mathematically advantageous zone!

How does that work?  If it's custodial accounts for your kids, then that money is now their money and can't legally be used to pay back your car loan.  You'll have to use your own money for that:

Yup, and that's fine.  We make regular contributions to custodial brokerage accounts and 529s for the kids out of our income, and instead our income will go to the loan and the cash in the custodial accounts will be for those contributions, therefore continuing to benefit the kids.

Right.

It's still not clear to me that you understand that:

1.  You're currently losing money on your car loan, and
2.  The contributions to your kids doesn't change the fact in #1.

[catccc]

Hm, maybe I am missing something?  Taxes are now 0%.  Interest income the kids get at 5.05% is more than interest expense we pay at 4.99%.   And that's if we keep them in cash.  Some of this will shift to equities and we'll expect a better return.

[TMB]

Check what the difference is for insurance and origination costs of the loan. You will likely be required to have gap coverage which might push you further into the pay cash camp.

I don't think I have ever been required to carry gap insurance, even when putting 0 down. Is that a new thing?

Some lenders require it, but it's usually optional.

Just wanted to comment: if someone requires GAP insurance, they need to include that in the finance charge (cost of credit) of the Truth in Lending disclosures.  I would be shocked it they do, and a failure to do so would be a violation of the law. 

[secondcor521]

Hm, maybe I am missing something?  Taxes are now 0%.  Interest income the kids get at 5.05% is more than interest expense we pay at 4.99%.   And that's if we keep them in cash.  Some of this will shift to equities and we'll expect a better return.

What it seems like you're trying to do is consider the money in your kids' account as offsetting the loan balance.  That's why you're saying "Taxes are now 0%" and "interest income the kids get at 5.05% is more..."  Is that what you're thinking?

If that's what you're thinking, then I think you are probably missing something.  But let's confirm that part first and continue from there.

[catccc]

If your point is that that money is technically no longer offsetting the loan as it can’t be used to pay the loan, sure.  I don’t need to think that for this to work and I’m not sure that matters at this stage.  We had the choice to pay cash for a car with or do something else with the cash and take a 4.99% loan.  We found it makes mathematical sense to do something else with the cash, so we did.

We could ignore the cash entirely - let’s say we did that move to UTMA independently of the car purchase as a tax minimization strategy. (I wish I had done it sooner, tbh the whole car loan question moved me to it.)  Instead, assets in our taxable brokerage account could have been liquidated to pay for a car, bc this is also true. Anticipating better than 4.99% returns, we decided to take a 4.99% loan.  Money is fungible, whether it’s the cash in our name, the kids, or the brokerage assets offsetting the loan is a nominal declaration and you can support any path here by choosing one. 

I am happy carrying the loan at this rate, because based on my analysis, it’s likely my family’s collective financial picture will be better for it. If you are saying it def will not, I don’t think we are on the same page. If your saying it might not, that’s fine.  I can agree with that, it depends on what investment returns I see in the time I carry the loan and how much I can bring the effective rate down.  Working on that part of the plan now. There are many opportunities to BT to 0% card for 18 months with a 3% fee, that’s a great effective rate! I dabble in the points and miles hobby, so it isn’t any additional time for me to evaluate these offers, I’m already doing it.  I’ve learned it takes time to build strategic debt without collateral. I’m carrying a fair amount of CC debt at 0% with more offsetting balances in cash. This car purchase was an opportunity to rev up the strategic debt side of our balance sheet.  (I’m in the don’t pay off your mortgage club, if you couldn’t tell. 2.75% and sometimes I doubt my decision to put enough down to avoid PMI.)

On the gap insurance… there was small print that it was included in the loan when they first gave me the paperwork.  I asked for it to be removed.  You do have to look out for it.  I also quickly ran the figures through an amortization schedule of my own to make sure there was nothing else hidden/rolled into it.

[catccc]

I am deliberately staying out of the "but do you really need a new car?" drama, because that's your call.

Staying out of it by… replying about it?!  Hm, okay. 

To satisfy your curiosity- We don’t really need a new one, but the new 2023 we got with 6 miles on it cost less than the 3 year old equivalent with 25K miles.  So it was a no brainer for us.  Sure, we could have gotten a 10 year old car with even more miles for less, but they aren’t exactly bargains on right now either, and we’d have to do this whole buying a car exercise sooner than later again. (We could have gotten an 18 year old car for way less, but we wouldn’t buy that, because it would probably need a new clutch and catalytic converter, which is why we are selling it.) We buy new or new-ish, take care of them, and drive them until repairs cost more than the car is worth.  It’s worked for us for a long time.

[Dicey]

I am deliberately staying out of the "but do you really need a new car?" drama, because that's your call.

Staying out of it by… replying about it?!  Hm, okay. 

To satisfy your curiosity- We don’t really need a new one, but the new 2023 we got with 6 miles on it cost less than the 3 year old equivalent with 25K miles.  So it was a no brainer for us.  Sure, we could have gotten a 10 year old car with even more miles for less, but they aren’t exactly bargains on right now either, and we’d have to do this whole buying a car exercise sooner than later again. (We could have gotten an 18 year old car for way less, but we wouldn’t buy that, because it would probably need a new clutch and catalytic converter, which is why we are selling it.) We buy new or new-ish, take care of them, and drive them until repairs cost more than the car is worth.  It’s worked for us for a long time.

1. You're asking a question on a forum that has specific, and very strong, opinions about cars.
2. I offered my thoughts. That's what people expect when they ask questions on this forum.
3. Discussing it is not remotely the same as telling you what to do, which I did not.
4. If you had quoted my comment in full, it might be easier to see that I said "that's your call", and did not tell you what to do. I am still not telling you what to do.
5. I am actually not particularly "curious", especially in light of the data in your siggy line. You can clearly afford it.
6. In the light of the new information, in your situation, I'd probably have made the same decision. DH paid cash for his 2002 Ford F150 and its still going strong. We bought my 2014 Toyota used in 2016 and we still refer to it as our "new" car. He does all of our repairs. It's possible that you and I have more in common than you might think.
7. You seem to be taking offense where none was intended.
8. Can't we just be friends?

[catccc]

Sure, let’s be friends!  Not offended, just explaining.

I also wonder if there’s been a shift in the level of frugality here.  I was reading another post about a 50k truck at 7.99%.  Have we all gone soft?! Or maybe we all got rich and could be soft?!  I’m truly trying not to be, but there’s a lot at play here. I wonder how many people got to a nice NW, possibly enough to retire, but have concerns on whether it was really enough, and now, due to recent inflation, don’t have a handle on what $ is worth anymore and how much is okay to spend.  I budget at a detailed level, but with enough flexibility that these questions still come up.

We previously did our own repairs when possible, too.  I do have to say that with this new car, it feels like I am driving a sophisticated computer, and I have likely valid concerns that it is not such a simple machine, one that will require more expertise to maintain.  But also likely valid thoughts that I will be able to get more miles out of this one. Hopefully the Toyota reliability is proving it’s worth for us still in 15-20 years.

[Finances_With_Purpose]

Main issue now is Toyota and other dealers have started putting crap transmissions in (CRT) to boost mileage and make CA/US mileage/emissions standards.  Markets the car better, but you get to pay to replace the transmission a lot sooner.  (Just ask your mechanic about it.)  Such an annoyance, but it's hard to avoid, especially for all but the largest SUVs/trucks.