It is said the single monthly commitment that can derail a plan to build wealth is paying a car loan.
Most car loans are so-called upside-down loans as the value of the car depreciates faster than the loan is being paid off, especially with a seven- to nine-year loan tenure.
So, which is best to finance a car purchase – cash or a car loan?
An upside-down loan is when the amount of the outstanding car loan exceeds the current market value of the car.
For example, a car can be sold for RM50,000 but the outstanding loan is RM60,000. So, if the car is sold for RM50,000, the seller still has to fork out RM10,000 to settle the loan.
This happens if the car depreciates in value faster, let’s say 50% in two years, and it was financed with a loan of 90% or more of the value at a loan tenure of nine years.
Here are three things to consider to make a wiser decision when buying a car.
1. The value of a car
The value of a car falls over time. It does not matter if it was paid for in cash or with a car loan. So, to be prudent, consider buying a lower priced car that serves the purpose, or not to buy one at all. A car is a financial liability and its value depreciates over time.
2. Financing the purchase
Say someone has RM100,000 and they want to buy a car costing RM100,000. They can pay cash so there is no loan to service. They would save themselves an effective interest rate of 4% to 5% per year.
This is fine if the focus is remaining free from debt. But they lose RM100,000 in capital that could be used to build wealth.
The purchase can be funded with a 10% down payment and the balance 90% with a nine-year car loan.
That would leave RM90,000 cash in hand, from which the instalments of RM1,100 per month can easily be paid.
Whether it’s worth it depends on how the RM90,000 is used. If it is invested in Amanah Saham Bumiputera (ASB) that yields 6% a year, the interest income would be RM5,400 income per year.
If the effective interest rate of the car loan is 4% per year and interest expense is RM4,000 (RM10,000 x 4%), that would be RM1,400 in net interest income.
Thus, you are paying for the interest on the car loan with interest earned from ASB.
In other words, it makes more sense to finance a car purchase with a loan if you are a good investor who can achieve an investment return greater than the effective interest rate of the car loan.
3. Debt service ratio
So, the car has been purchased and the instalments amount to RM1,100 a month. For someone earning RM5,500 a month, the instalments come to 20% of the monthly income, working out to a debt service ratio (DSR) of 20%. That is if there is no other outstanding debt.
If there are other commitments, such as PTPTN, credit cards or personal loans, work out what the DSR would be after buying the car. If someone is paying RM440 a month in PTPTN instalments, their DSR would increase to 28% from 8%.
- Before buying the car = (existing loan commitments / monthly income) x 100% = (RM440 / RM5,500) x 100% = 8%
- After buying the car = (existing loan commitments + car loan Instalments) / monthly income) x 100% = (RM440 + RM1,100) / RM5,500) x 100% = 28%
So, calculating the DSR would help determine if someone can really afford to buy a car with a loan.
If the DSR after buying the car is above 40%, they may want to reconsider because they could be over-gearing. They could end up in financial distress if they lose their job, business or source of income.
Are there plans to buy an investment property two or three years down the line?
Most people do not realise that the RM1,100 a month in instalments that finances a RM90,000 car loan is worth as much as RM220,000 in property mortgage.
Essentially, the individual is committing RM1,100 a month for RM90,000 to buy a car that depreciates in value while forgoing an opportunity to acquire a property worth RM240,000 that could generate rental income and appreciates in value over time.
So, those looking to buy a property in the near future should not take a car loan and use their loan eligibility for a piece of real estate.
This article first appeared in kclau.com
Ian Tai is the founder of Bursaking.com.my, a platform that empowers retail investors to build wealth through ownership of fundamentally solid stocks. It is an essential tool that sifts out stocks that grow profits consistently from a database of over 900+ stocks listed mainly in Malaysia.