The Low Interest Debt Debate

by Dual Income No Kids on March 26, 2009 · 0 comments


Hi All,

There is a very good posting at a blog I read quite frequently called The Simple Dollar. The blogger there, Trent, discussed his families decision to get a car loan even though they had enough to pay for the car with cash.

For some reason, the decision stuck in my head. While I have tremendous amount of respect for Trent – his blog is one the most popular and successful personal finance sites on the web – so it raised an interesting question: should you take out a car loan, even if its a low interest one?

Just to recap, Trent bought a 2009 Toyota Prius and took out a car loan at 4% interest. His family was able to take advantage of some favorable legislation which allowed them to deduct sales and excise taxes on the purchase price of the auto. In terms of choosing a car, the Prius is a good pick. The car is tremendously popular and has very good gas mileage. So, the purchase was a smart buy.

However, I would not have made the same decision. Here is why:

1) Loans generally reduce your purchasing power. For example, a 4% payment on a 4 year car loan, assuming the purchase price was $20,000 – would be about $451.81. This is a pretty big monthly nut to crack.

2) The interest on car loans is generally not tax deductible. Its not like a student loan or a mortgage in which tax law allows you to deduct the interest. Payments on notes secured by automobiles are considered personal interest by the IRS and are therefore generally not deductible.

3) Consumer contracts can reduce your personal autonomy. A key factor about living debt free is autonomy. If you owe someone money, typically you are contractually bound to perform certain obligations – like make payments, but more importantly the realities of contracts between consumers and large institutions is they tend to favor the institutions. The legal arrangements allow institutions to raise fees, rates, sell your own personal information, seize your property for non-payment, etc. Of course its a philosophic question, but shouldn’t one goal of financial freedom be to minimize the impact of these kinds of arrangements in your life?

However, the decision to borrow at 4% does make good sense in at two regards. First, Trent notes that paying cash for the auto loan would reduce his potential alternative opportunities to put his cash savings to good use. For example one could find good investment opportunities in bonds that would yield more than 4% after taxes. Second, having money in the bank provides a degree of security that wouldn’t be there if cash was paid for the car. He may be able to invest it and get a better return, and in turn build his wealth instead of having it locked into an asset that loses value quickly as well as over time.

So, to quickly recap, should you take out a car loan, even if got a super low interest rate? Well, it depends on your personal situation, but I would not make the choice.

Best,

James

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