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I've heard people saying that a car loan is considered a bad debt, while a house mortgage is a good debt and so on.

My bank is offering 1.49% interest for a 36 month loan or 2.49% for a 37-60 month loan.

I need help with calculation here because if I calculate this correctly I don't see any 'bad debt' here.

If I buy a car for $15k, I end up paying only $223.50 more within 36 month. Or $373.50 more in 5 years.

This doesn't seem to be a bad loan. To pay $373 more in 5 years is definitely worth keeping savings and instead finance a car.

Note: So I realized that the amount $223.50 is annual rate. So in 3 year it will be $670. Or $1865 in 5 years. Still pretty good for relatively new car. I normally spend $3k servicing an older car bought by cash.

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    Normally, the discussion of good debt / bad debt takes into account the appreciation or depreciation of the asset you're purchasing with that debt. In general, houses appreciate in value while cars depreciate. – GalacticCowboy May 1 '15 at 20:13
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    @GalacticCowboy: whether houses really are an appreciating asset is extremely debatable. It depends on the market and even on the culture. In Japan, houses are very much considered a depreciating asset that has little or no resale value. – Michael Borgwardt May 4 '15 at 12:56
32

Here is another way to look at it. Does this debt enable you to buy more car than you can really afford, or more car than you need? If so, it's bad debt.

Let's say you don't have the price of a new car, but you can buy a used car with the cash you have. You will have to repair the car occasionally, but this is generally a lot less than the payments on a new car. The value of your time may make sitting around waiting while your car is repaired very expensive (if, like me, you can earn money in fine grained amounts anywhere between 0 and 80 hours a week, and you don't get paid when you're at the mechanic's) in which case it's possible to argue that buying the new car saves you money overall. Debt incurred to save money overall can be good: compare your interest payments to the money you save. If you're ahead, great - and the fun or joy or showoff potential of your new car is simply gravy.

Now let's say you can afford a $10,000 car cash - there are new cars out there at this price - but you want a $30,000 car and you can afford the payments on it. If there was no such thing as borrowing you wouldn't be able to get the larger/flashier car, and some people suggest that this is bad debt because it is helping you to waste your money. You may be getting some benefit (such as being able to get to a job that's not served by public transit, or being able to buy a cheaper house that is further from your job, or saving time every day) from the first $10,000 of expense, but the remaining $20,000 is purely for fun or for showing off and shouldn't be spent. Certainly not by getting into debt. Well, that's a philosophical position, and it's one that may well lead to a secure retirement. Think about that and you may decide not to borrow and to buy the cheaper car.

Finally, let's say the cash you have on hand is enough to pay for the car you want, and you're just trying to decide whether you should take their cheap loan or not. Generally, if you don't take the cheap loan you can push the price down. So before you decide that you can earn more interest elsewhere than you're paying here, make sure you're not paying $500 more for the car than you need to. Since your loan is from a bank rather than the car dealership, this may not apply. In addition to the money your cash could earn, consider also liquidity. If you need to repair something on your house, or deal with other emergency expenditures, and your money is all locked up in your car, you may have to borrow at a much higher rate (as much as 20% if you go to credit cards and can't get it paid off the same month) which will wipe out all this careful math about how you should just buy the car and not pay that 1.5% interest.

More important than whether you borrow or not is not buying too much car. If the loan is letting you talk yourself into the more expensive car, I'd say it's a bad thing. Otherwise, it probably isn't.

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    I have the cash but I like seeing it in my account. I would rather have savings for emergency situations than nice car and no money to buy gas...So taking loan just to make me feel I have savings, that's my desire. I wonder if it's wise... – Grasper May 1 '15 at 17:13
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    @Grasper: Wanting to have savings liquid as a "rainy day fund" is definitely wise. But once you have your cushion, it's a good idea to add what you reasonably can to your car payments and pay down the principal quickly. – Mason Wheeler May 1 '15 at 18:10
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    @Grapser: "taking loan just to make me feel I have savings", is in effect borrowing money just to keep it in the bank. If, by sitting in the bank, it's protecting you against rainy days, then it might be well worth paying for up to a reasonable value for an emergency fund. But if you're paying for the privilege of feeling like you have assets because there's a nice number on your bank statements, when actually you're in net debt because the new car drops in value the moment you drive it away, that's a "bad debt" :-) – Steve Jessop May 3 '15 at 14:44
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    @SteveJessop - I understand your objection. But, as I note in my answer below, if he depletes his savings, buying in cash, but then needs $10K for whatever reason, what is his cost of funds? I'd rather borrow at 2.5% and keep the cash on hand. A small price to pay to have that cheap money. – JTP - Apologise to Monica May 3 '15 at 18:12
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    @JoeTaxpayer: sure, if $10k is (for you) a reasonable emergency fund that you wouldn't otherwise have, pay $149 or $249 a year for it as (in effect) insurance against paying a higher rate for a personal loan later. It's a matter of how far below your comfortable savings total you'd be taken by paying upfront, how many months it would take you to save back to a "safe" amount of savings, that kind of thing. – Steve Jessop May 3 '15 at 21:53
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"Good debt" and "Bad debt" are just judgement calls. Each person has their own opinion on when it is acceptable to borrow money for something, and when it is not. For some, it is never acceptable to borrow money for something; they won't even borrow money to buy a house. Others, of course, are in debt up to their eyeballs.

All debt costs money in interest. So when evaluating whether to borrow or not, you need to ask yourself, "Is the benefit I am getting by borrowing this money worth the cost?"

Home ownership has a lot of advantages:

  1. Everyone needs a place to live. If you don't own your own house, you'll need to pay rent to someone who does own a house.
  2. Owning your own house can give you a level of freedom to customize your living space that you don't have living in someone else's house.
  3. Homes tend to increase in value over time, or at least hold their value. (Depending on the location, market conditions, condition of the house, insert your own disclaimer here.)
  4. In the U.S., Property tax that you pay on your own home is income tax-deductible. Property tax that you pay as part of your rent is not.

For many, these advantages, coupled with the facts that home mortgages are available at extremely low interest rates and that home mortgage interest is tax-deductible (in the U.S.), make home mortgages "worth it" in the eyes of many.

Contrast that with car ownership:

  1. Cars are convenient, but not absolutely necessary to own. There are alternative methods of transportation. (This, again, depends on location; certain parts of the world are easier to navigate without cars than others.)
  2. Cars almost invariably decrease in value over time, often very rapidly. There are very few exceptions. This fact makes it likely that you will spend at least part of the time in debt owing more than the car is worth.
  3. Cars offer no tax deductions, in the U.S.
  4. Cars vary wildly in price. With houses, in the same location, generally more money gets you a bigger house. You can get a car that will carry 5 people from one place to another for $1,000 or for $50,000. Buying a more expensive car than you need is a luxury.

For these reasons, there are many people who consider the idea of borrowing money to purchase a car a bad idea. I have written an answer on another question which outlines a few reasons why it is better to pay cash for a car.

  • Note on your #4 for the house, interest on a mortgage is also tax deductible (in the US), if your itemized deductions are more than the standard deduction. – jamesqf May 1 '15 at 18:04
  • @jamesqf I did mention that in my answer in the next paragraph. The numbered list of home ownership advantages are available to all homeowners, whether or not they hold a mortgage. – Ben Miller - Reinstate Monica May 1 '15 at 18:10
  • With regard to point #4, there is a significant difference in per-year service cost between a 4-year-old car and a car which is similar but 10 years older. There is also a significant difference in the likelihood that an unexpected failure will leave the car immobilized in an awkward position. Someone willing to accept a higher risk of getting stranded can own a car much more cheaply than someone who isn't; in some cases, risk aversion may be a luxury, but in other cases it may be driven by 100% practicality. – supercat May 1 '15 at 18:39
  • About home ownership #2, having a lot of capital tied up in your residence can also reduce your flexibility. If you're renting, and for some reason need to relocate, depending on the terms of the lease the most you are likely to lose is a few months' worth of rent. The same cannot be said if one owns a home (regardless of whether it's a house or apartment, and of whether one has a mortgage or not). – a CVn May 4 '15 at 11:54
  • @MichaelKjörling True, the freedom you get with ownership is not necessarily financial freedom. I was referring to the freedom of being able to do things with your home that you can't do as a renter. – Ben Miller - Reinstate Monica May 4 '15 at 12:01
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Just to argue the other side, 1.49% is pretty low for a loan. Let's say you have the $15k cash but decide to get the car loan at 1.49%. Then you take the rest of the money and invest it in something that pays a ~4% dividend (a utility stock, etc.). You're making money on the difference.

Of course, there's no guarantee that the underlying stock won't drop in value, but it might go up, too. And you'll likely pay income tax on the dividends. Still, you have a good chance of making money by taking the loan.

So I will argue that there are scenarios where taking advantage of a low interest rate loan can be "good" as an investment opportunity when the risk/reward is acceptable.

Be careful, though. There's nothing wrong with paying cash for a car!

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    this is a good suggestion. – Grasper May 1 '15 at 17:08
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    Another benefit of a low-interest loan is to boost credit history. If you pay an extra $500 in interest for a car loan, but it enables you to get a mortgage when you wouldn't have had the history without it, or especially if it raises your credit enough to save you a fraction of a point on a mortgage, it can pay for itself many times over. – Kevin May 2 '15 at 20:57
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    -1 for suggesting leveraged stock investments without a full understanding of the OP's situation and risk tolerance. – a CVn May 4 '15 at 11:55
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A car loan might be considered "good" debt, if the following circumstances apply:

  1. You qualify for a super low interest rate (e.g. 0.9% to 1.9%). In that case, the manufacturer / dealer are basically subsidizing your loan to help sell their cars.
  2. The availability of the car loan is not enticing you to buy a car that is wildly more expensive than what you can comfortably afford.
  3. Taking the car loan frees some money for more a productive use. For example, if your mortgage has a higher interest rate than your car loan, then use the money to prepay your mortgage. That's a no-risk gain for you!

If, on the other hand, you only qualify for a subprime loan, or you're borrowing to buy a needlessly expensive car, that's probably not a good idea.

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    I agree. My wife and I financed our car only because we got a 0.9% rate (which they only gave us because we threatened to pay cash). It's a cheap way to add positively to your credit history, in addition to the other points you list. – Kevin May 2 '15 at 21:01
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What's missing in your question, so Kate couldn't address, is the rest of your financial picture.

If you have a fully funded emergency account, are saving for retirement, and have saved up the $15K for the car, buy in cash.

If you tell me that if the day after you buy the car in cash, your furnace/AC system dies, that you'd need to pay for it with an $8K charge to a credit card, that's another story.

You see, there's more than one rate at play. You get close to zero on your savings today. You have a 1.5% loan rate available. But what is your marginal cost of borrowing? The next $10K, $20K? If it's 18% on a credit card, I personally would find value in borrowing at sub-2.5% and not depleting my savings.

On the other side, the saving side, does your company offer a 401(k) with company match? I find too many people obsessing over their 6% debt, while ignoring a 100% match of 4-6% of their gross income.

For what it's worth, trying to place labels on debt is a bit pointless. Any use of debt should be discussed 100% based on the finances of the borrower.

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The risk besides the extra interest is that you might be upside down on the loan. Because the car loses value the moment you drive off the lot, the slower you pay it off the longer it takes to get the loan balance below the resale value. Of course if you have a significant down payment, the risk of being upside down is not as great.

Even buying a used car doesn't help because if you try to sell it back to the dealer the next week they wont give you the full price you paid.

Some people try and split the difference, get the longer term loan, but then pay it off as quickly as the shorter term loan. Yes the interest rate is higher but if you need to drop the payment back to the required level you can do so.

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The good debt/bad debt paradigm only applies if you are considering this as a pure investment situation and not factoring in:

  1. what owning the asset gives you, and
  2. the alternatives to the asset.

A house is something you live in and a car is something you use for transportation. These are not substitutes for each other! While you can live in your car in a pinch, you can't take your house to the shops.

Looking at the car, I will simplify it to 3 options:

  1. You can not own a car and use public transport and/or sponge off friends and relations
  2. You can buy a "cheap" (a relative term which you can put your own meaning on) car
  3. You can buy an "expensive" (ditto) car.

You can now make a list of pros and cons for each one and decide the value you place on each of them. E.g. public transport will add 5h travel time per week @ $X per hour (how much you value your leisure time), an expensive car will make me feel good and I value that at $Y.

For each option, put all the benefits together - this is the value of that option to you. Then put all of the costs together - this is what the option costs you.

Then make a decision on which is the best value for you.

Once you have decided which option is best for you then you can consider how you will fund it.

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