After my post about steps of getting a car loan, a friend wanted to know if it was wise to actually buy a car with a loan? I thought it was an interesting question and similarly thought there are several people out there who might just want to know. So, lets attempt to analyse in our usual simple manner.
Friend: I want to buy a car. Do I need to get a loan for it?
Me: I hate to answer questions with questions but permit if I do. How much is the car you want and do you have enough money to purchase it?
Friend: Well, I like the 2010 Toyota Corolla and I hear I can get it for N3.5m. I have N5m in the bank though. So I can actually pay for it. But I still want to know what is the benefit of financing it with a loan
Me: Now I get the clear picture. The decision on whether to fund the purchase of a car with a loan or with your own money is one of opportunity cost. But for starters, you do not purchase the car entirely with a loan, at least in Nigeria. You must fund part of it with equity. So lets discuss first the benefits of purchasing the car with a loan
Benefits:
Intro: A lot of people view debt as a very bad thing. Sadly, that is not true. The richest people are often the ones mostly in debt. Even the riches country in the world. USA, has the highest amount of debt in the world (about $13trillion). The main thing to worry about debt is the maximum limit that your finances can carry. Once that is established then you will have no problem. I understand the psychological comfort being out of debt gives but whilst the risk of reward is gone, the benefit goes with it as well. So, an employee of a company should ideally have a debt repayment of about 25% of his salary for starters. Meaning if you earn N100k monthly, then whatever debt you take out should not exceed N25,000 monthly from your salary. That way you are still able to save and meet up your other expenses. Therefore, if you wish to obtain a car loan which you intend to repay over 4 years, then the loan amount you should be targeting should be about N800k. That automatically puts the car at N1.36m as the bank will mostly only finance 60% of the car. This means a salary earner of N100k should be able to afford a car of N1.36m (financed by a loan of N821k and equity of N548m) provided he takes no other loan, be it for house rent or party, or wedding loan. It is good to bear this in mind as people often take on loans that are beyond their capabilities. With this in mind, lets now delve into the benefits
Opportunity Cost
Me: You said you had N5m meaning you can actually pay for the car? Do you have a regular source of income like salary
Friend: Yes. I earn N400k a month.
Me: Lets put that to test. Since you earn N400k a month, 25% of that is N100k a month. The maximum repayment you can make based on N100k a month at a 20% interest rate and a 4 year term (48months) is about N3.28m. So with N2.1m as the loan you seek, you are covered. Remember, if you were to borrow money from the bank you would borrow (using the amortization schedule which I gave in my prior blog) N2.1m (that is N3.5m multiplied by 60%). With this your salary can pay for the loan without using your savings.
Now to the opportunity cost. Assuming you have decided to borrow N2.1m from the bank to part fund the bank rather than your own money. At a cost of N887k for the entire four years the loan see amortization schedule , then you must make over N900k from the N2.1m over the next four years. To simplify it, you must make at least N225k every year on the N2.1m (assuming we ignore the time value of money). That way you have used the money better than the bank has.
Cash flow : I have always believed that one must keep some sizable amount of money in the bank. Regardless of what people say, cash really is King. It is good to own investments but you must always keep a sizable amount of cash in the bank. There could be an emergency that requires immediate cash payment, or even an investment opportunity that can yield you good returns. Using the above example, what if you are told to suddenly to supply an equipment for N3m at a cost of N2m to you. You have made N1m already, covering the total interest the car loan will cost you. In addition, you still have the N2.1m with you and the car as well. Meanwhile, if you had purchased the car with that N2.1m, you may then need to either sell it or borrow again to fund your business. You and I know how a difficult scenario that is especially if there is an urgency attached to the LPO (Local Purchase Order).
Car, an asset or a liability: I often hear a lot of people refer to cars as liabilities. Especially as they feel it does not generate revenue. Whilst it is true a car doesn’t generate revenue in that sense it is wrong to view it as a liability. In actual sense a car is an asset. A car is just like a house, or clothing or TV or Computer that you mostly need for everyday activities. All these items are funded with money isn’t it? For example, your TV or Computer doesn’t necessarily generate revenues does it? These are all tools that we use to generate revenues out of our physical or mental efforts. Therefore, just as you choose to live in Surulere rather than Ikoyi because of rent, so you should choose the kind of car that suits your cash flow (that you can afford).
Credit History : At some point in life it is often important to take a loan. This might be to finance a project, build a house or pay for your school fees. Depending on the urgency and importance of the need, getting a loan on time can be a very important factor. Therefore, loans like car loans, personal loans are often good for your record provided you service them adequately and don’t default. These records make up your credit history and aid in making a bank decide to give you a loan and even reduce your interest rate. In fact, if you have a good track record with a bank they can go as much as cutting interest rates at 2% below market rates or prepare the cash flow to suit you needs rather than the banks. Lets remember banks make money by giving our loans, so they always like good customers
Good Car: A car loan makes it easy for you to buy a brand new car. A lot of people who shy away from car loans, preferring to fund it themselves end up buying ‘Tokunbo” cars. After 2 years of owning the cars, they end up fixing them thus raising their maintenance cost. They also do not have warranty on the car and sometimes end up with accidented cars. News cars tend to last as much as 5years before you start to think of checking the engines or major parts of the car. In fact once you buy them all you need to do is service them regularly.
A Business Concern : Imagine that you are a company that is into supplies of diesel that requires about N10m of supplies every week. You suddenly need to buy 2 trucks costing N3m each to help increase your supplies. Will you finance it from equity (thus holding on supplies) or just take a bank loan? For companies it is mostly financially expedient for them to finance capital expenditures with loan. That way they can free up cash and use for other investments that generate higher returns.
Summary: Whether buying a car or a house the choice of how to finance it depends on your income. If you take too much debt that is higher than your income, then you are planning for financial disaster and as such it may not be wise to get a car loan.. A car loan may well be a wise decision if you take a debt that is compatible with your income. It also helps if you have the benefit of using the cash for other productive ventures provided the opportunity cost of using it is higher than the interest that you pay the bank. Opportunity cost can be financial or personal it all depends on your yardstick.
