How do you know when you should pay cash or finance a big purchase in your life? Well, there a couple different ways you can determine what will work best.
You may be thinking if you have the cash then why would you borrow money and pay interest? It turns out it’s not that simple and may even be advantageous to take a loan out!
When to Pay Cash or Finance
Thought Nugget: In the event, you have the cash to buy an expensive item such as an automobile, a piece of property, or even a boat, why would you prefer to borrow funds rather than make the purchase there and then?
Tip: Surprisingly, a majority of the people borrow money more often than not, especially when interest rates are quite favorable.
Logic: Borrowing money at lower interest rates can earn you more on the funds you invest; therefore, in this case, it is cheaper to acquire a loan as compared to paying cash.
Many individuals are convinced that it is crucial to avoid debt at all costs. Maybe you share such thoughts. It could be that you have encountered an enormous debt or you know someone who has, and you have witnessed the distress that accompanies debt.
The opportunity cost of financing
Whether you finance or you pay cash or not for a large purchase, additional costs exist in relation to the asset’s price. In case you finance, the cost is evident: it is the interest that you will pay on the loan.
On the other hand, when you decide to pay cash, an opportunity cost will be incurred in the future investment returns or interest you could earn from retaining that money.
For example: In your savings account, you have $10,000, earning 2% annual percentage yield. For every year, that rate compounds monthly. Therefore, in a record one year, you will earn an interest of $202. Over three decades, you will receive $8,212 in terms of interest. Sounds interesting, right? If you choose to spend the $10,000, you relinquish those profitable earnings.
As interest rates are increasing by the day, you could even get a much higher harvest on your savings.Things become more interesting when you contemplate the projection of earning a long-term average of 6% to 7% on finances channeled in a steady portfolio of bonds and stocks.
Despite the fact that actual returns are hard to forecast and rely on several aspects, 6% to 7% can be considered a good rule of thumb. Given those returns, the opportunity cost for spending $10,000 significantly rises when you think about the magnitude that compounding will have over the years.
Illustration: Financing an automobile at 2%
Loans for new vehicles are examples of low rates that consumers can incur. At times, these rates are subsidized by the manufacturers to encourage purchases.
Better still, without subsidies, financing for new vehicles is quite low since creditworthy individuals pay them back, and if they default, it’s rather uncomplicated for banks to reclaim the car.
Bonus tip: When considering financing a car, do not borrow from a dealership — reaching an agreement with a salesperson can be quite challenging. Try loan aggregates who can offer you the best rates. They can even assist you in locating individualized loans that suit your needs.
Leave your emotions at the door!
As a human being, your feelings count in decision-making. The decision of when to finance or pay cash can be influenced by logic or feelings. More often than not, emotions can get in our way when we need to make objective choices.
It is usually, in such situations, a matter of either thinking with your head or following your heart. The thought of having a hefty balance in your account can dissuade your capacity to earn a significant amount from it.
It’s totally understandable to keep the money; however, with the discussion on opportunity costs, it is practical to conclude that it is not entirely a smart move. The same applies to individuals who would instead accrue debt than enhance their investments. While that may be a tactical approach, sometimes the figures don’t add up.
From the above discussion, it is pivotal to engage in in-depth assessment before you make the crucial decision of when to pay cash and when to finance. Think smart!