Understand Capital Costs

by Philip Brewer on 10 August 2009 10 comments
Photo: Philip Brewer

Especially for things people often buy on credit, like a car or a house, there's a tendency to divide the ownership into two periods--while the loan is being paid off, where the item is expensive, and after the loan has been paid off, where the item is free. This is a fundamental misunderstanding of capital costs.

Ordinary items are an extreme case of this. A new t-shirt or coffee mug costs a few dollars one time and then lasts for a year or twenty. Once you pay for it the "expensive" phase is already over, and now the item is "free" for however long it lasts. Items bought on credit only seem different because the "expensive" phase lasts longer than a moment.

Economists and accountants long ago figured out that this is the wrong way to think about capital costs. Each field came up with a slightly different path toward a correct understanding--accountants talk about depreciation while economists talk about present value--but it's the same idea.

Imagine that you pay $20,000 for a car that's going to last 10 years. If you pay cash, one way to think about it is that the car costs $20,000 in the first year and then is "free" for the next nine years. That's not an insane way to think about it--that's what your actual cash flow looks like--but it doesn't lead to smart decision making. It's somewhat better to think of it as costing $2,000 a year for 10 years--that'd be pretty accurate in a world where interest rates were zero and you always knew exactly how long the car would last. Since interest rates aren't zero and you don't know in advance exactly how long the car will last, you need to make some adjustments. (Accounting is all about the rules for making those adjustments, so that one company's accounts can be compared to another's. The tax man has a certain interest as well.)

The insight that the economists had is that what really matters is the interest rate. If you buy a car you might borrow the money--but then you have to pay interest on the loan.  Alternatively, might pay cash--but then your cash is tied up in your car and can't be invested in something else. If the interest rates were the same, it wouldn't matter to you which one you did. (At least, it wouldn't matter to an economist.)

In simple cases, like deciding whether or not to take out a car loan, people's intuition serves them well enough--you know that the interest rate on the loan will be several percentage points higher than what you can earn on your savings, so paying cash makes sense if you have the cash. You also know that making the car last as long as possible is a win however you pay for the car. But in more subtle cases, simple intuition can lead you astray.

For example, suppose the location of your current home means that need to have two cars so that two adults in the household can both get to work. If you moved someplace where one person could get to work some other way (on foot, by bicycle, via public transit), you could get rid of one car. The economic analysis involves comparing the costs of the second car to the difference in rent. But--and this is the key point--it doesn't matter whether the car is paid for or not.

In a situation like that, the simple-minded analysis is to add up just the cash costs of the car--fuel, insurance, registration, maintenance, etc. This leads you badly astray if you imagine that having a paid-off car is different from having one where you're still making payments. The capital cost of your car is completely independent of whether you're currently making car payments. If you adjust your household situation so that you can get by on one fewer car you reduce your expense profile by the entire cost of maintaining that second car--including the capital cost. (One way to think about it is that you no longer need to be saving up to pay for its replacement.)

From a purely economic perspective, the only difference between buying something on credit and paying cash comes from the difference in interest rates. In the real world, of course, there are other differences--a debt constrains your future freedom, while cash in the bank expands it. But the purely economic perspective is worth understanding so that you don't make this kind of mistake.

 

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some guy on the internet

I think this article adds a great perspective that I really didn't envision before.
I too feel better about an item after I pay if off for some odd reason. Just this past March I finally paid off my car and somehow I like it better than I did before. The thought of someone still having an interest in an item of mine leaves me feeling a little uneasy. I suppose it is because if I don't make that last payment they can still "take it back". After it is paid off it finally feels safe.
Thanks, keep up the good writing!

Guest's picture
spaces

I should show this to my spouse. He doesn't get why, when we had two cars (no payments) but needed only one, I included the extra car in my 'what do we have if we liquidate now' rough calculation and its associated expenses in my rough 'expenses we could stop real fast' column. Since we only needed one, the second was convenient, but IMO truly saleable, and represented a monetary asset we had tied up tangibly, like a stock or an extra bicycle. The spouse is not much of a finance guy, and I haven't been able to put it in words he understands. But you have explained this very well!

Guest's picture

I agree with the previous comment, you did explain this very well. Thanks for the help!

Guest's picture
Rosa

There's a lot of personal finance writing about managing cash flow, but not much about actual finance. Thank you for getting this out there.

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Guest2

People just don't understand how much money cost in the long run. Opportunity cost... once it is spent ... it is no longer available. Make sure you need things before you buy them. There are not enough storage buildings to hold all of the stuff... things.. junk

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Mark Ross

Great article. We are a 1-car family and are lucky enough to be in a position to have some cash that was given to us. Should we pay off our single car, or invest the cash instead? Our APR on the car is not great... Can't remember it off the top of my head, but I doubt we could make a higher or even equal return if we invested for the same amount of time that we have remaining on our loan...

Philip Brewer's picture

@ Mark Ross:

I just last month wrote a post on When to use savings to pay off debt.  Very briefly:  You will want to compare interest rates, but first you want to make sure you have an emergency fund.

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Brian

Another great post, Phillip. I would like to see this kind of analysis tied into a discussion about true cost of ownership including residual values of an asset. Cars are great examples of how shopping the lowest price tag could still cost you more. Typical personal finance discussions usually relegate these examples to a cash flow analysis only (e.g., "don't spend more than 20% of your take home pay on car payments").

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Debbie M

I'm actually pretty good at thinking this way about cars because I've made my monthly cash flow match my monthly cost. I always pay cash for my cars. Every month, I save $160 toward gas, insurance, maintenance and repairs and $53 toward my next car. Of course different amounts of money come back out of that account each month based on whether insurance came due or I bought a car that month, etc., but it's easy for me to see my monthly cost.

With a house, it's different. I'm only buying one (probably) and I have a loan. Looking at my cashflow, I've been spending about the same to own as to rent every year except the year I bought the house and the year I refinanced, when I spent more (closing costs). But I've been thinking that once it's paid off, my decision will feel much more wise.

Better would be to also notice the equity I am getting (even though I plan never to use it). That would matter if I were comparing getting a different house, remodeling, renting, or relocating.

But maybe you're saying that instead I could calculate all my expenses over the rest of my lifetime and divide by the number of months to get my real monthly cost. Hmm. The first thing I notice is that by the time I'm 77 my cash flow will be back to where it was when I first bought the house even though my house will be paid off because of inflation in the other costs. Maybe I should do it all in today's dollars. In today's dollars, if I live to be 100, my overall monthly cost will be only 60% of today's cost. If I live to be 80, the cost is 65%. But those numbers don't take my equity into account. If I subtract the total value in today's dollars, that brings my monthly cost down to about 33% of my current cash flow costs. This feels all very weird.

I think I'd rather just wait until I compare something. Like if I buy a different house, if it's worth 25% more, that will probably raise all my costs (repairs, taxes, insurance) by about 25%. And if renovating, I could compare that additional cost to the additional cost of buying a comparable house.

Philip Brewer's picture

I've written before about valuing houses and how to think about equity.  I think, though, that you do understand the issue.

The point is not that you need to divide the cost over your entire life, but that you understand that when you pay the cost doesn't make much difference.  Paying cash for a car is cheaper than getting a car loan, but only because the interest charged on the car loan is greater than the rate you can earn on your savings account.  (In a bizarro world where savings accounts paid 12% but car loans only cost 0.5%, you'd want to get the biggest car loan you could and stash your cash in the bank.)

It's easy for the timing issue to confuse things, though.  My wife knew a guy who wrote a successful play and made enough money to buy a brownstone in New York.  The guy could have paid cash, or he could have gotten a mortgage (with a larger or smaller down payment).  Which he did made a difference on a cash-flow basis, but it really didn't make any difference on a capital basis.  Owning a brownstone free and clear with no money in the bank versus owning a brownstone with a big mortgage but lots of cash in the bank is just about the same thing--in fact, if mortgage rates and savings rates were equal, it'd be exactly the same thing.  The fact that he had made a bunch of money gave him options about the timing of when to pay, but which option he picked made no difference to the cost structure of his household.