Everyone has financial goals like buying a house, a fancy car or another luxury item. While some of these are assets for your future security, others stem out of your aspirations and ambitions. It is no doubt a great achievement to purchase them on your own. However, some of these items may cost you a bomb. During such times, you may find yourself in a fix over the decision of financing the purchase or paying in cash.
To some people, financing comes automatically. They prefer to pay in small installments instead of losing a major portion of money from their bank accounts. They choose to avail loans even it if means paying more in the long term. However, it is not always the right choice. Read ahead to know when it is a better idea to finance and vice versa.
Calculate how much your action is going to cost you
If you take a loan, various miscellaneous costs are going to add up to your total expenses. Apart from the interest in the total amount availed, you will also have to pay the loan processing fees and a penalty for early loan repayment. However, it will give you the freedom of continuing with your current lifestyle.
On the other hand, you will be saving up on these charges if you choose to pay in cash. However, you will be losing your interest rate earnings if you were to invest this cash. Moreover, everybody is not comfortable in spending a huge amount of their hard-earned money in one go.
So, how do you resolve this conflict?
Well, the answer to your question is rather simple. You need to understand the opportunity cost of your cash. In simple terms, the opportunity cost refers to the benefits you will be losing out if you select one alternative. For instance, it may be a tough decision to choose between babysitting your niece and going to a concert. Attending the concert would mean losing out on precious time with your favorite niece. Choosing to babysit would mean waiting for another couple of months before you can see the band perform live.
Similarly, if you choose to pay in cash, you will lose the interest you can earn on your investments.
Let’s take an example to understand this in detail.
Suppose you have a balance of $20,000 in your savings account and you add another $200 every month. At an APY of 2%, you can earn an interest of $42,480 over 30 years. Isn’t that amazing? Well, this amount is the opportunity of using your cash for the payment. Also, there are other investment options that can give you a rate of return in the range of 6-7%. The opportunity cost, in that case, will become all the more significant.
Thus it will make more sense if you take a loan if you get an APR which is less than 2%. In reality, it is hard to find such a deal. Opt for a loan if you get it an interest rate which is less than 5% as you will still end up being in profit. If you have a considerable investment in the stock market, you will still be making profits with the loan.
What are the other aspects that you must consider?
Sellers are always interested in buyers who are ready to pay in cash. More so, if you are buying a house. The reason for this preference is the risk of loan rejection. Therefore, you must seek special discounts if you are ready to pay in cash.
Financing a purchase has its own set of pros and cons. Firstly, you can build a solid credit report if you pay your monthly payments regularly and on time. If you don’t, you may risk the opposite. Besides, certain types of loans can give you tax advantages. However, you may have to compromise on your current lifestyle, as you will be left with lesser disposable income every month.
Another disadvantage of investing your money while taking a loan is that your investments may not yield the desired results. It is advisable to evaluate your risks to resolve this situation.
In conclusion, financing is not always the best option. Assess your opportunity cost to arrive at the right decision.