That’s right. You heard that correctly.
It’s financially better to use a invest money into a 2% Certificate of Deposit (CD) instead of paying off a 3% car loan directly.
The math checks out.
Buying a $35,000 Car Scenario
Here’s the scenario, you want to buy a $35,000 car.
Assume the following:
- 5-Year Term
- A 5-Year CD has an annual yield of 2%
- The interest rate on a 5-Year car loan is 3%
So you take $35,000, put that into the 2% CD.
Use that $35,000 CD as collateral to finance the $35,000 car for 5 years.
Your monthly car payments can be calculated using the following formula (which is the same formula as a mortgage):
M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1] P = principal loan amount i = monthly interest rate n = number of months required to repay the loan
Or in Excel you can use the following function:
=PMT(interest rate/12 , number of months, loan amount, 0)
In this case, this formula becomes
=PMT(3%/12, 60, -35000 ,0) =$628.90
Therefore, your monthly payments for the car will be $628.90 per month. After the 5 years, or 60 months, is up, you will have paid a total of:
$628.90 x 60 = $37,734.25
How Much Did the 2% CD Make?
Now let’s take a look at the 2% CD.
I’m using Ally Bank’s information since a lot of people use them for their high rates. According to this page, interest is compounded daily.
Using the link on that page to go to the compound interest calculator, we put in the numbers to calculate how much money we’ll have after 5 years with our 2% CD. This results in the following:
I wanted to double check this number on Excel. I used a Future Value formula to determine the result after 5 years:
We notice that there’s a difference of $763.84 between my calculations on Excel compared to the compound interest calculator on Investor.org. This can be attributed to the difference in the number of compounding periods. Given that the loan is for 5 years, I counted for 1 leap year in my formula.
This is all predicated on the fact that you can get a car loan at 3% and find a 5-Year CD for at least 2%. Of course the higher the CD, the better.
The bottom line is that regardless of which calculation we do, the 2% CD shows a higher value after 5 years. In the most conservative scenario, the CD has a future value of $37,917.04 and the car loan shows a total paid amount $37,734.25.
This results in a net profit of $182.79.