Roanoke Times
                 Copyright (c) 1995, Landmark Communications, Inc.

DATE: MONDAY, July 23, 1990                   TAG: 9007200687
SECTION: BUSINESS                    PAGE: A/5   EDITION: METRO 
SOURCE: MAG POFF BUSINESS WRITER
DATELINE:                                 LENGTH: Long

IS IT BETTER TO BORROW?

The dealer had tried to talk her out of paying cash to buy a car, she said, insisting that she'd save in the long run by borrowing money.

Is it possible to come out ahead, she asked, by investing her cash in a bank CD while borrowing a like amount at a much higher interest rate?

A quick answer is that it is indeed possible. The dealer also has the edge in the argument about the psychology of how most of us handle money.

If you're both flush with cash and disciplined, however, you're better off "borrowing" from yourself and paying off your own loan.

The adjacent chart shows several calculations by a Roanoke auto dealer, a bank and a financial planner who considered the woman's question.

Like the consumer, the dealer and the bank didn't want to be identified because of their business relationships. But they said the situation is not unique to them, because many dealers make similar presentations to customers.

All of the interest figures used in the calculations assume that the amount of money needed to buy the car is $10,000.

Under the first scenario, that amount could be invested in a bank at 8 percent interest. After five years, the dealer figured, the bank account would grow to $14,898.46.

Over the same five years, he said, the buyer would pay $3,000.80 in interest on an auto loan, assuming the rate is 10.85 percent.

At the end of the deal, he said, the buyer would possess a car - then probably worth $3,500 - a net of nearly $1,900 in interest plus the original $10,000 still in the bank.

The dealer contends anyone who used cash to pay for the car directly would end up with a vehicle valued at only $3,500. That argument, however, overlooks the extra cash flow from avoiding the $218.68 monthly payments for a five-year auto loan.

The banker came up with figures that varied only slightly.

A few dollars' difference in the deposit earnings is due to the fact that banks compound interest quarterly, instead of monthly as the dealer calculated.

The banker also assumed charging 11.25 percent interest on the auto loan, the current rate in this area. The rate would be 10.85 percent only if the dealer surrendered all of his commission the bank would pay him for placing the loan.

The reason for the gain on the interest in both cases is that the buyer borrows at simple interest. He pays diminishing interest dollars on a declining loan balance.

The bank deposit, on the other hand, is compounding as interest gained one year earns even more interest in the next.

In the first year, for example, the CD earns $830. With that extra amount added to the balance, the account's second-year income is $898.88.

By the fifth year, the CD is pulling in $1,141.80.

This equation works only over time. The dealer estimated the break-even point at three years.

People who intend to finance for a shorter period, or who are thinking about paying off early, should pay in cash if they can, the dealer said.

The bank's calculation for a four-year loan illustrates the narrower margin in the shorter time.

A four-year tabulation is listed because of the danger in financing a car for five years. The buyer always owes more than the car is worth, so he is in a deep financial hole in case of an accident or a resale.

Despite that, the dealer and the banker agreed that many people today finance for five years so they can drive more expensive cars.

Andrew Hudick, a registry financial planner with Fee-Only Financial Planning Inc., said the calculations are like comparing a lump-sum benefit with the periodic payments of an annuity.

Pushing such a comparison, he said, is the old "baffle 'em with B.S." technique.

Hudick said taxes would reduce the gain on the bank deposit by either 15 or 28 percent, depending on the individual's income tax bracket.

If the bracket is 28 percent, he said, the five-year earnings would shrink to $3,341.

Another consideration is that after this year, none of the loan's interest charge can be used as a tax deduction unless the buyer uses a home equity line. But that capitalizes the debt as a mortgage against the house for up to 10 years, long after the car has probably gone to the junk heap.

Hudick would pay the $10,000 in cash and make the monthly payments of $218.68 to himself by putting the money in a bank.

He figured an average bank interest at 6 percent, assuming the payments would go initially into a lower yield savings account before they accumulate to a sum needed for a higher-rate CD.

Anyone who follows that course, Hudick said, would earn bank interest on the payment interest and wind up with $5,334 on top of the original $10,000.

Hudick had two caveats.

The first is that you don't sink your only savings into a car. If $10,000 is all you have, keep the cash as an emergency reserve and borrow the money.

The second is that many people will make car payments faithfully but are tempted to divert funds intended for savings.

Unless you're sure you have the discipline to pay yourself the full amount every single month, borrow the money. Nor should you borrow against your house unless you have the determination to pay off that debt in five years or less.