Understand Capital Costs

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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.