The Great Debate
It seems like every time I go into a personal finance forum, there is always some yay-hoo with the top thread asking how much down payment they should put on a loan or whether it’s a good idea to pay a loan off early.
It’s like asking if it’s better to stand or sit while wiping and yes, there is a debate on that. You’ll get vehement and compelling arguments from both sides, but ultimately it will boil down to your personal situation and temperament.
On one extreme you can put 100% down and pay in cash. Great. No loan, no monthly payments and all peace of mind. But maybe you could’ve started a side business with that cash instead and quadrupled it in 8 months. This “what else could I have done with the money” scenario is typically called the opportunity cost.
On the other extreme you can put 0% down and start your side business with the intent to pay off your loan after you quadruple your cash. Instead, your business idea sucks and your investment goes to zero. You also can’t sleep at night because you still have a “like-new” loan balance with a hefty monthly bill.
The solution to this, as with most other conundrums, probably lies somewhere in the middle. You want to ensure you won’t default on your debt but also want the flexibility in case opportunities (or calamities) occur. Does this sound too good to be true? Good, because it is. You’ll pay for this flexibility in the form of interest expense and self-discipline, but it might be an option to consider.
Samwell T. Buys a BMW
Let’s look at a hypothetical man named Sam T. who is financing a 2016 BMW M3 for $100,000 at an interest rate of 2% APR.* Assume Sam earns $3,000 per month but spends every penny to provide for his wife and new son. Sam’s parents are wealthy however and gifts them $110,000 for producing a grandson.
Scenario 1: 100% Down Payment
Sam was raised to never hold debt because debt is the devil. Well, okay then. He hands over the $100k for the car that will put all souped up 1999 Honda Civics in their places. As a result, there’s only $10,000 left in Sam’s bank account, but at least he’s debt free with no monthly payments.
Unfortunately, he still has other monthly bills of $3,000, and winter is coming. A White Walker comes by and stabs Sam in the leg rendering him unable to work. Disability insurance doesn’t cover White Walker attacks, so Sam has no income now.
In less than 4 months, Sam’s $10,000 is gone and now he needs to sell that sweet M3 to the highest bidder to buy some ramen noodles for his family. The highest bidder is some teenage punk looking to trade up his 1999 Honda Civic and offers Sam $50,000. Sam curses and threatens him with Dragonglass but with his baby getting hungrier by the day, Sam takes the much needed cash.
After a few months, Sam’s leg recovers, the Mother of Dragons fights off all the White Walkers, and Sam can go back to his day job. Life is good again and he wants his M3 back. He finds the punk that took it from him, and he is actually willing to sell it back to Sam…for $75,000. This results in a $25,000 loss for Sam.
Scenario 2 – 0% Down Payment
Sam was raised on credit cards and is comfortable with debt. He decides to put 0% down and finances the entire cost of the vehicle. Sam’s bank account balance remains at a cool $110,000, but now he has a new monthly payment of $1,750 assuming a 5 year loan.
After a few days, the same stabby White Walker renders Sam unable to work. Although Sam’s monthly burn rate is now higher at $4,750 instead of $3,000, he can sustain these losses for close to 2 years before he considers selling his M3 due to his cash reserves in the bank. In Scenario 1, Sam could only hold out for 4 months.
Fortunately for Sam, his leg recovers in less than a year, and he was able to reclaim his income while keeping his baby (the M3). The cost of interest on the $100,000, 5 year loan at 2% APR was an average of $90/month. At the end of the 5 years, Sam will pay about $5,000 on top of the original price of the car. This is the price of flexibility when things don’t go your way, and they never do.
Recommendation: So What’s The Answer?
One might argue that Sam should not have bought a car he couldn’t afford in the first place, and that would be correct. However, it could just as well be your house, stock investments or businesses you’d be forced to sell if all your cash was tied up in equity from a down payment. And for a final kick in the crotch, when crap really hits the fan, every other chump will be out there panic selling alongside you, further lowering your sales price.
Thus, it is essential to have a sizable cash reserve when taking out a loan so you can weather the storms or take advantage of opportunities. If you’re not able or willing to part with at least 30% of the total cost in cash, you likely can’t afford whatever you’re trying to buy. If you do have 30% though, it doesn’t mean you have to spend it all on the down payment. In fact, the maximum I would ever put down on a loan is 25% and pay off the loan in lump sum whenever the time or situation calls for it. I would not make additional weekly or monthly principal payments because you’ll just be tying up your cash without reducing a single penny on your monthly obligation. Sure, it may feel like you’re wasting money on interest but what you’re truly paying for is flexibility in the future.
This is where self-discipline and personal tendencies come into play. If you’re going to put down 5% and spend the other 25% on Tamagotchies or other worthless crap, you’re better off with a higher down payment and additional principal payments. Further, you should never take out loans with interest rates more than 6% unless it’s for a business venture you’re confident in. If you don’t have the cash to avoid financing at those rates, then you must revert to what our ancestors did – save money. If you do have the required cash reserves, have the self-discipline, and your loan has a low interest rate then the final task is determining if the price of flexibility is worth it. I’m sure it was well worth it for Sam, but what’s the right answer for you?
Readers, what is your down payment policy and how much do you value flexibility versus peace of mind? Some have told me if you can’t pay in cash then you can’t afford it, but perhaps these people don’t value opportunity costs. What is your criteria for affordability?