As I mentioned in my introduction plan article (here), I am new to thinking about financial decisions. Historically, I have been scared to use any type of debt to finance anything. I have always saved up my money for big purchases and paid off credit cards every month. If I did not have the cash then I could not afford the item. It was a simple logic. A few years ago, I decided not to finance a luxury vehicle, but instead save and write a check. I thought that there was something cool about answering 'how will you pay for this car?' with 'Oh, I am just going to write a check.' I felt like I was sticking it to the man yelling, "You are not going to get me with your finance charges!" I thought that I had won. Then I discovered that I am an idiot. (Many would suggest that this was discovered a long time ago.)
I have started thinking about money different over the past few months. While I am lucky that I discovered that I needed to save more money to meet my retirement goals, I also am lucky that I have figured out how to think about personal finance. When I started investigating my car, I realized that I am leaving a lot of money on the table.
I am planning on selling my current car. For sake of example, lets say that I can sell it for $30k. Since I paid cash for the car, I will have this amount to "spend" on a new car. Instead of spending the cash on the next vehicle, I am planning on financing the car. The current highest rate that my bank is publishing is 1.74% for a used car for up to 6 years. With my new retirement education, I know that Mr. Market is willing to return a pretty good percent over the long run. In this case, I do not have the long run. I want to compare what would happen to the money if it were all the money that I have to spend on a car. In order for me to be willing to make this investment, I need to identify something with a low beta and a decent dividend. This of course led me to utilities. But which do I pick? I decided that any individual stock would be too much risk.
This sent me to investigate ETFs. Then XLU came to the rescue. SPDR's XLU is a passive investing strategy aimed at mirroring the performance of the S&P 500 Utilities sector. The current top 5 holdings are Duke (DUK), Dominion (D), Southern (SO), NextEra (NEE), and Excelon (EXC). Many of those names are on the portfolio list of the folks here on Seeking Alpha. It also has the advantage of a current expense ratio of 0.18%. But the biggest advantage that I see is its low beta of 0.37. Since I want to use this is a trade off analysis, I want to know that I have relatively small risk over the six years that I 'invest' for my car. So, what is the impact of this decision?
Let me do a quick recap. I am going to sell my car of $30k and take on a loan for $30k. The $30k that I take out in cash will be invested in XLU. I will sell my shares of XLU to make the car payments from the $30k that I have already saved and used to pay for my previous car. The idea is that the incremental share value growth plus the generous dividend will make up for the cost of taking out the loan at 1.74% for 6 years. The current yield of XLU is 3.75%. That is a good start. In addition, the following is the performance of share price appreciation over respective time frames:
14 (Inception - 1999)
To take the conservative approach, I will use the lowest value of 1.8% as the growth rate for shares. Here is what the values look like for the 6 year loan. I am going to use this conservative estimate to also cover up for transaction cost and capital gains taxes. Without the conservative estimate, I would need roughly 2.8% return to cover those costs over the six years.
Retained Value (W/Dividends)
Over the life of the loan, I will pay $1,614.97 in interest. For my $30k in cash invested in XLU, I expect to have a remaining balance of $9,033.75 including the $4,241.53 that I will reinvest in dividends. This value represents a savings of 30% over the life of the loan versus paying in cash on day one. That is amazing. This money plus the residual value of the vehicle will be a great way to "save" for my next car purchase.
What Loan Term Is the Best?
When I started looking at this I was confused at what would be the best term. So I did the math on each year from 4 to 6. Below are the results.
Retained Value (W/Dividends)
Note: All time periods are investments over 72 months. Payments would stop relative to their respective time frames.
By using a longer loan, you allow your money to compound longer as opposed to using the principal as part of a payment. The extra two years of investment and dividends are what make the difference. Now, I know that many of you will argue that with the reduced need to have a low beta, the 2 years could be invested at a higher rate of return. I agree. But for this analysis, I want to keep it as simple as possible.
With today's low interest rates, there is a big trade off between paying cash and using financing to make your large purchases. My recommendation is save up to make the purchase, use financing to pay for the purchase and reap the reward for your investment savvy. You can even start before the purchase by investing your savings while you are saving.
As always, I look forward to the comments on this plan as well as other investments that might make sense outside of XLU.