Loan Might Be Better Than Giving Cash for Car At first, psychology Professor Geoffrey of Berkeley, Calif., rejected out of the hand his Toyota dealer's offer of financing: He had saved up the price of a new corolla and, like many people, didn't want a loan because that's the way I'd been brought up." The dealer even told him he could earn more on the same S8,300 in a 8 percent certificate of deposit than he'd pay out on a 14.2 percent car loan, "but you don't believe it, "he said. "It's counter intuitive: Anyone can see 14 is bigger than 8." He's not unusual. Many people who spend their adult lives avoiding debt have heard from (usually richer) friends that it's generally better to spend borrowed money than savings, but they can never clearly see why, particularly when loan rates are higher than inwestment yields. What's more. Keppel said, "when you've just spent several hours nickel-and-diming with an auto dealer, you're not inclined to jump when they say they have another good deal for you." Worked It Out That night, however, Keppel awoke and went to his computer to "work it out for myself, month to month." Calculating different investment yields and weighing them against the total interest that he'd pay on the 14.2 percent loan, he saw that he'd break even with only a 7 percent investment, he'd make almost S1500. A couple of points must be added here. First of all, this seems a rather exclusive quandary, concern only of affluent people who have the option of paying outright for their car. But it really isn't. According the J.D. Power & Associates, an automotive market research firm, one-third of the people who buy cars do pay cash, and some of the two-thirds who don't probably could. Second, it's a quandary only today's buyers can easily solve: Yesterday's consumers didn't have calculators and personal computers for such analysis, and it's laborious to wok out by hand. They might otherwise have seen the advantage in borrowing without taking anyone's word for it. Keppel, for example, calculated that 48 months of interest on a 14.2 percent loan of $8,239.05 would be $2,607.62., while the same principle invested at 8 percent, compounded monthly, would earn interest of $3,095.06--a profit of S457.44. Tracing both transactions month by month, he could also see that the reason it worked to his advantage was that "the 14 percent is applied to a declining balance, and the 8 percent is on an increasing balance. Indeed, over four years, the average outstanding balance of the loan -- the average amount on which he'd be paying interest -- was only about half the total amount borrowed. His investment, on the other hand, would earn interest on the full deposited principal, plus continually compounded interest, throughout the term Generally speaking, an easy rule of thumb as if you can earn an interest rate equivalent to half the interest rate on your loan, you'll come out ahead," said Frank Sperling, vice president at Security Pacific National Bank.

Should Professor Keppel pay cash for his new car?

1. What is the monthly payment Mr. Keppel will need to make on his car loan?

2. What is the "total interest paid" on the loan? Is the 2,607 number correct?

3. How much interest will he earn on his savings?

4. What is Sperling's Rule?

5. What is the right decision? Why?

Answer rating: 100% (QA)

The professor should take the loan and invest the cash based on the interest rates and earnings vs i... View the full answer