By: Mike Earl, CFP®, CPWA®
Statements you will hear outside TWG’s walls, but not inside them:
“Money is really cheap right now.”
“I get a tax deduction on this, so it’s a good deal.”
“The dealership is providing interest-free financing on the new model; it’s a great deal.”
“We refinanced and are saving $300/month on our payments.” [while starting the clock on a new 30-year mortgage]
One of our main goals is to help clients get beyond the mindset of “what’s my monthly payment on this?” When interest rates are low, lending rates are low – leading to lower monthly payments on debts. And when the costs of borrowing fall, consumers are tempted to borrow more money.
But ask yourself this question: why does the car dealership offer interest-free financing? Are they trying to cut you a really good deal out of goodwill? The obvious answer is that interest-free financing spurs consumers toward spending more on vehicles. Setting aside the question of interest rates, would a car dealership rather see you walk out with a $50,000 vehicle or a $15,000 vehicle? They’re willing to lose a bit of money on the financing of a new vehicle, in exchange for you spending $5,000 - $10,000 (or more) extra on the new vehicle.
If the dealership can get you thinking about what a great deal 0% interest is, they can get you to forgot the sticker-shock on a brand-new vehicle. Total dollars out the door is what they’re after, and it’s also what you should be focused on.
Interest rates are just noise. We want our clients to grow their net worth. When our clients consider what car or home to buy, we help them think about how that decision will affect their net worth over time.
Consider the following hypothetical scenario of a 2020 car buyer.
The brand-new Tesla gives you the “cheap money” of an interest-free loan, whereas the used Honda loan carries a hefty 6% interest rate.
Which option is the better financial decision? When I set it up like this, the obvious answer is the Honda Accord.
But most of the time, the decisions you face aren’t this stark. The differences are more subtle, more sneaky.
Vehicles depreciate. We all know this.
Homes, on the other hand, typically appreciate in value over time. This makes the lure of stretching for a home purchase even greater.
With today’s low interest rates on mortgages, should we use that “cheap money” (or you can call it leverage, to sound smart) to buy the most massive home we can afford?
Of course not.
Would it be better for you to own a $400,000 home with a 6% interest-rate on the mortgage, or a $800,000 home with a 4% interest-rate on the mortgage?
I will take the less expensive home with the more costly debt any day of the week. Ceteris paribus, allocating $400,000 to a low-returning, costly asset like a home is far better than allocating $800,000 to a home — even if the interest rate is higher on the $400,000 home.
We all have finite resources. Those resources get allocated across our different needs and wants. If we allocate too much of our finite resources to homes and vehicles, we don’t have enough to properly fund saving and investing for the future.
I realize none of this is rocket-science. But I think most of us can be tempted by the prospect of “cheap money”, losing sight of what should be the foundation of our decision-making process: how will this decision impact my net worth?
And for the record: I have nothing against Teslas or luxury homes — provided they are purchased when the time is right. For many drivers of fancy motor-carriages and owners of fancy homes, it’s a classic case of Big Hat, No Cattle.
Because The Wealth Group, Austin B. Colby & Associates is independent of Raymond James, the expressed written opinions above are our own and not necessarily reflective of Raymond James’ opinions.