Benjamin Franklin once said, “Money makes money. And the money that makes, makes money” really refers to compound interest and it being referred to as the 8th Wonder of the World.
Helping Johnny Appleseed
There is always an opportunity to grow your money tree or improve your financial situation. A close friend of mine, let’s call him Johnny Appleseed, asked me for my advice on what he should do with a recent bonus of $20,000 on an after-tax basis. With how the market has been behaving lately, many of us will jump to the conclusion of investing it. For me to provide a recommendation, I needed more info to help him. After an initial discussion of understanding his money tree (net worth statement), it was a clear recommendation. As an avid reader of this blog, he was very diligent about the use of his credit cards, paying them off every month and earning rewards along the way. But one debt remained, his auto loan.
There was approximately $19,300 left on the auto balance with an interest rate of 4.75%. He was paying roughly $385 a month with 59 remaining months left until it was paid off. In doing the simple math, he was set to pay a little over $2,437 in interest payments over the duration of this loan. The key question that I asked him was, “Do you think you can earn a return of 6% in the stock market? if so, then invest it there but I caution you on the risk profile you must assume.”
So why 6% and not 4.75%?
Many of us forget about the tax impact of our capital gains since it is normally settled during the annual tax return process. Assuming a 20% tax rate on a long-term capital gains basis, that is equal to a smidge better than 4.75%. That is the threshold on this investment decision between value creation and destroying value.
So what are the alternatives?
One option is to place the $20,000 in an Ally savings account. This can be a measure of an “emergency” fund while earning an APR of 0.5%. With this option, Johnny A. will have $20,489 in his account at the end of the 5 year term. In that same time frame, would have paid out $22,436 in monthly auto payments. The difference is seen as value destruction to his Money Tree by almost $2,000.
Here is a graphical representation of the two options: Pay off Loan or save
I am never a fan of paying interest on a depreciating asset, such as a car. Also, I do think you can negotiate a better deal when purchasing a car if you had many financing options available to you at the time of purchase. I then proceeded to tell Johnny to continue to make the monthly payments after the loan payoff to a brokerage account. From there, depending on the investment profile, you can then accumulate another $22,974 over the period of the original loan payment table. This option helps create two things: (1) an emergency fund, albeit a smaller balance upfront and (2) ability to use the cash to negotiate on the next car purchase providing more flexibility and purchasing power. Don’t forget that at the time of the next car purchase, don’t write-off the leasing option as well, which reminds me of the time I helped another friend help negotiate a car lease, here is that summary if you are interested.
In closing...
Seems like common sense but it is surprising how many people fail to act or get comfortable with not maximizing their balance sheet. A key element of this blog, many small steps produce great results over the long term and before you know it your Money Tree is bigger than you ever expected.
I am a finance professional with over 20 years of experience and very passionate about all topics related to finance; enjoying the aspect of teaching and educating others along the way. All in all, I will show you how big this money tree can get over time as I get the branches (Earn, Save, Invest) as high as possible…Click here to see my financial progress to date: How high is the Money Tree?
