The answer is not a simple as one might think – it depends on how old you are and how expensive the loan and/or car are. This question refers to those who are already retired and are not saving any more. What they have is all they got; from their portfolio and from Social Security and/or maybe a pension.
There is a cross over point during retirement where taking on debt, for example to buy a car, depends on your age – more specifically, how much time remains to repay the debt compared to simply paying cash through a lump sum withdrawal from your retirement portfolio.
Simply thinking in terms of interest costs is incorrect because there is a larger long term effect on cash flows and portfolio balances when the money now comes from a retirement portfolio instead of the old fashion way from just a pension or Social Security once you’re retired. Now that you have saved up a pot of money for retirement, interest payments and principal have a total combined effect on cash flow and portfolio balances, it is not just a question of how much interest you pay anymore.
Here’s a cash flow assessment to illustrate this question: Given today’s environment … Should you buy a car* with cash, taken as a lump sum from your retirement portfolio**? Or should you take out a car loan?
The first frame in the image above shows the annual cash flows and portfolio balances each year for a 65 year-old couple***. The brown columns show the baseline values without taking a loan, in other words, the prudent normal annual income possible from the beginning of the year’s portfolio value. Notice the withdrawal rate rises slightly each year because the time remaining slowly decreases.
I’ll point out here that the values are from the portfolio only. Additional income would come from Social Security and a pension if there is one. One’s total income would be the sum from all income sources during retirement. Arguably, the source for an “extra” expense such as car replacement would come from the portfolio since Social Security and pension income are fixed. Let us look at how that “extra” income should be handled.
The yellow columns show the effect on cash flow and the portfolio balance by paying for the car in cash taken as a lump sum withdrawal from the retirement portfolio. Notice that the total sum of lifetime cash flow is less than the baseline cash flow (brown column sum). The cash flow and portfolio value differences for each year, and the lifetime cash flow total is shown in the blue columns. The bottom of the blue column is the sum of the differences between the baseline (brown) and paying for the car lump sum (yellow).
The green columns show the effect of a car loan payment* (interest and principal) on the cash flow. Obviously the net cash flow available for other living expenses is reduced because of a car loan (just like net cash flow always was reduced when one was working too). In other words, the car loan payment is subtracted from the total prudent cash flow for the year (green values subtracted from brown values). Once the car loan is paid off, the total net income is the same again (purple highlighted value) as the baseline from that point forward. Notice that the total of the GREEN SUM, is LESS THAN the total of the BLUE SUM. This means that the lump sum cost more than taking out the car loan (ratio is 1.53) because the small reduction in monthly cash flow (blue column) lasted permanently over the remaining lifetime of the retirees, while the green column was temporary over the same lifetime.
Now, does the answer change for a different 75 year-old couple? Yes it does. The columns in the second frame of the image above are adjusted for age and this couple buys the same car with the same loan. The only difference is that this couple is 10 years older than the first couple (they had the same cash flow and balances between ages 65 and 75). The column discussion for the second frame is the same as for the first frame above.
The lump sum ratio over the loan is 1.08, in other words, taking out the loan is slightly more advantageous for this couple too. If they were older, the ratio would go under 1.0, in which case paying by lump sum would have a better potential lifetime outcome at that point.
How about keeping the cash flow the same for spending and ADD the loan payment to the cash flow … in other words, withdraw more for a short period of time? How does this compare to the above example where the loan payments were subtracted instead. Adding the loan payment is typically done, especially in low interest rate environments like today, because the perception is that the money is there and they don’t want to reduce their other spending otherwise.
One could temporarily change the portfolio withdrawals by adding the car payment amount to the baseline prudent cash flow amount (brown values), instead of subtracting loan payments. However, the effect from doing this is a more rapid reduction in the portfolio balances during these early years due to the extra loan payments added to normal withdrawals. The overall effect is a larger monthly reduction in cash flows after the loan is paid because the portfolio values are permanently less than what they would have been if they had instead subtracted the payments from the prudent cash flow.
I ran the comparisons for such a scenario and the conclusion is the same because of the extra drag on portfolio values from adding payments in the yellow column to the prudent cash flow amount (brown column). The “paid from portfolio” cost more ratio, after the loan is paid, was 2.10 at age 65 and 1.36 at age 75. Trying to have your cake and eat it too turns out to be the worse option. Remember how you paid loans during your working years? You paid for loans out of your current income – you did not get a pay raise because you had loans. So your net spending on other things had to be reduced because of the loan payments. It’s the same during retirement too! Paying for loans should come from your prudent income since your portfolio can’t pay for more than it can support without consequences. Those consequences are an even more reduced income later after car purchase for the rest of your life.
So the moral of this story (adding payments to normal income) is that one can spend money only once. The more you spend now, the less you’ll have to spend later! Not only is the money spent to pay the loan, but those extra withdrawals also lose growth on that spent money too. Get the transportation you need rather than buying more than you need.
Does one want a permanent small reduction in income that adds up to more over the same time frame, or a temporary larger reduction in income for the car payment, that simply reduces overall total normal cash flow by the total of all the car payments? The answer to the question depends on how a retiree has structured their budget. In other words, do they have discretionary room in their budget to make a car payment for a few years, like people tend to do during their working years?
If so, then taking out a loan is less costly, in terms of lifetime cash flow, in the long run. If not, then paying for the car by lump sum is their only option, even though this is more costly in the long run because the payments (i.e., cash flow reduction because of reduced portfolio balance), although less, is permanent for the rest of one’s life – and the greater the number of years remaining, the greater the overall cost effect on cash flow of the one-time purchase years earlier; at least until one has reached their late 70’s where the lump sum ratio is close to, or less than, 1.0.
At older ages beyond the mid 70’s, it generally is best to pay by lump sum from one’s portfolio.
I also looked at what happens with higher interest rates, or more expensive cars, either of which increases the overall annual outgo of cash. In general, the higher the payments (or more expensive the car) the more the answer tilts now towards a lump sum solution.
In summary, the three options evaluated are:
1) Add loan payments to prudent withdrawals you’re already taking (the worse option across the board). The most tempting to do with the worst outcome.
2) Pay for the car in cash as a lump sum withdrawal (poorer option as a younger retiree; better option as an older retiree). Also tempting since you simply hand over the cash; however, other factors are also in play.
3) Take out a care loan and pay for it out of prudent withdrawals you’re already taking – like you did when during working years, you paid debt out of your earned income that didn’t go up simply because you decided to borrow (better option as a younger retiree; poorer option as an older retiree).
Moral of the story: One should compare lifetime cash flows between paying a lump sum for a large purchase, versus getting a loan. So what’s the rule of thumb here? The rule of thumb is to do a specific evaluation with one’s specific circumstances to see which way, lump sum cash or a loan, makes the most long term sense. Many factors have an effect on the outcome including interest rates and how much the replacement car is.
What about a mortgage? Should one have one in retirement? The answer to this question is similar in that paying for a home via lump sum permanently reduces the cash flow from the remaining portfolio balance. Is the reduced cash flow more or less than what the principal and interest payment is for the loan?
The answer is a bit more complex because of the effect of the loan on standard of living. When does the mortgage end in relation to expected longevity age? In other words, will there be a number of years after the mortgage is paid off where a boost in monthly income, now that the mortgage has been paid, would be advantageous for health expenses for example. Also, can one save enough for retirement so that the portfolio value can include both the mortgage payments as well as other living expenses? If not, then paying off the mortgage during working years may reduce the measure of one’s standard of individual living (SOIL) such that a higher retirement savings amount may not be needed, BOTH for the mortgage payment and the lower measure of standard of living (because one is used to living on less if extra is being paid on the mortgage, not for a higher SOIL). However, remember that property taxes and insurance must continue to be supported by the retirement portfolio. One should have an assessment done to compare accelerating a mortgage payment versus saving that additional money for retirement. How does each option affect your overall portfolio balance and how much income may you receive at, and during retirement, under each option.
*Average new car price in 2015 was $33,560 and round it to $34,000 for the example. Average new car auto loan interest rates in 2015 was 4.35% for a 5 year loan. For the example, the loan payment is calculated on the car price only, with no adjustments for sales taxes, fees, etc. since each locale would be different in these regards; the overall conclusion wouldn’t change even though the dollar amounts would. Auto loan payment equals $631.55 per month, or $7578.60 per year, for a total 5 year payout of $37,893.00.
**Portfolio characteristics: Balanced 50% stock/50% short term bonds, real return 6.01% and standard deviation 10.80%. Initial value @ age 65 is $500,000. One may be tempted to think higher returns would change the outcome, however what returns give, volatility takes away, and specific portfolio characteristics need to be considered as part of the evaluation.
***Withdrawal characteristics: 65 year-old couple using Annuity 2000 table, both living at each age. Raw withdrawal rate adjusted 1) by a factor of (1 – 1/n) where n = number of years remaining at each age from life table and 2) number of years remaining also adjusted every 5 years by adjusting longevity percentile (LP) of those who outlive cohorts by 5%, e.g., @age 65 LP = 50% (definition of expected longevity); @age 70 LP = age where 45% outlive their cohorts (this is a longer time frame relative to 50%, and thus the withdrawal percentage is lower relative to 50%); at age 75 LP = 40%; etc. Supporting research.
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