I get this question all the time. In fact, its one of the things I wrestle with in my own personal financial planning. Emotionally I find it hard to write a big check and pay cash for an expensive item such as a car or a home improvement project. Maybe you feel the same way. On the other hand, it may make sense to do so. Here’s why.
Let’s say the interest expense on your loan for a major purchase is 6%. There is also a cost to investing. Maybe 1.5% (or more), plus taxes. So to net 6% you would have to earn almost 9% on your investment (assuming a 15% capital gains tax rate) before taxes and investment expenses. Even if your cost of investing is low and you are able to avoid the capital gains tax, you still have to make more on your investment than you pay in interest on your loan. Where can you get a guaranteed 6% after tax net rate of return these days?
Logically it makes sense to avoid the loan, if possible.
If you avoid borrowing to pay for a big ticket item, you can take the monthly amount you would have paid in loan payments and redirect it into some type of long-term investment account earmarked for “future car (or other) purchase”. Then use those dollars to make your next major purchase with cash.
The above assumes you were to invest the cash in some type of long term investment, but what if the cash stays in a cash position and is never invested? In that case, you should still pay cash for big ticket items. Think of it this way, why borrow from one bank and pay a 6% interest rate just to keep your idle cash at another bank (or in some cases, the same bank) only to earn a paltry 1% or less on your short term savings?
In either case, you are better off paying cash rather than borrowing money to make major purchases.
Paying cash helps you pay less
If everything were equal, you would pay the same for a car purchased with cash as you would for a car purchased on credit. However, things are rarely equal. Human nature being what it is, if you pay cash for something you will probably spend less because it’s much harder to write one large check than it is to write several smaller checks over time.
Here is what I mean: when you are at the car dealership and they ask you if you want heated leather or just plain cloth seats you naturally ask “How much does it cost?” If the cost is $30 a month for heated leather seats you might reason that that’s a small price to pay for a warm tushy in the winter. On the other hand, if you have to write a check for $1,800 to pay for those seats, you might decide that your tushy is much more comfortable sitting on cold, hard cash. Paying cash not only saves you interest, but also provides an incentive to pay less in the first place.
IRAs change everything
Next time on The Bridge, I will kick it up a notch and take a look at taking money out of an IRA or other tax deferred retirement plan to pay down debt. Taking a distribution from an IRA or retirement plan changes everything. Read my next post to find out how.
Required Disclosure: Investing involves risk including the potential loss of principal. The examples here are hypothetical. Individual situations will vary and this is not intended to be a substitute for specific investment or tax advice.