When should you not avoid debt? When is it better to finance a purchase?
I think there are two requirements you need to meet before deciding to finance a purchase. If you can meet both of them, you should finance the purchase.
Rule #1: The monthly payment should put no strain on your budget
And by no strain, I mean you don’t need to get a 2nd job, or a raise to afford the purchase.
Rule #2 You can earn a higher return by investing your cash elsewhere
This especially applies to small business owners. When I think about paying cash for a large purchase (not that I will be doing that anytime soon), I immediately think of what that money could do if invested in my business.
Could I get a 10% return? Very, very likely. A 100% return? Also possible.
In fact, I would argue the case for financing personal purchases is very high for small business owners at significant income levels (see rule #1).
Car Loan Example
Let’s say you want to finance a $30,000 vehicle purchase. You have $30,000 in cash, and so you could pay cash and own the car free and clear. Dave Ramsey would be pleased if you went this route.
But lets run the numbers, sorry Dave.
Loan Amount: $30,000 Loan Term: 48 Months (4 years) Interest Rate: 7%
Monthly Payment: 718.39
Total Interest Paid: $4,482.59
Total Car Price: $34,482.59
When you can earn a higher return elsewhere….
Now, lets say that $718 a month isn’t a big payment to you (lucky you!). You would invest that $30,000 into your business and earn a 20% annual return. We will assume a tax rate of 35%, and inflation rate of 3.1%
calc source: dinkytown
Invested Capital: $30,000
Simple Interest: $15,600 Compound Interest: $3,314
Total Interest Earned: $18,914 after taxes and inflation
Wow. You earned nearly 15K by being able to invest at a 20% return, even with a 35% tax rate.
A realistic example using a 9% Return
One more example. Lets say you can’t quite earn a 20% return, but you can achieve a 9% return by investing in notes at Lending Club. And, since you’ve got great credit, you can get a car loan at 4.9%.
Loan Amount: $30,000 Loan Term: 48 Months (4 years) Interest Rate: 4.9%
Monthly Payment: 689.53
Your total interest: $3,096.99
Now, let’s assume you invested that 30K at Lending Club vs. buying the car with cash….
Simple Interest: $7,020 Compound Interest: $640
Total Interest Earned: $7,660 after taxes and inflation
What say you?
When would you finance something? Would you use my two rules? Or would you never finance a purchase when you could pay with cash?
{ 3 comments… read them below or add one }
I am working on getting better at paying all small daily bills with cash. The times I have taken advantage of credit is with 0% interest offers. I got LASIK done several years back where my loan would be interest free for 18 months. I paid it all off in 18 months so I did not pay a $1 of interest. Also I have had friends that purchased products from Best Buy/Circuit City that took advantage of purchasing TVs or stereos using the 6 month or 12 month 0% interest offers. This also helps you see if you can fit this purchase in your budget.
I don’t think I would ever finance something if I didn’t have to. I see the point you make about investing that money, but you would have to be running a very successful business to feel that confident about your investment (although, I could see $30k doing a lot of good for expanding a small business’ horizons). However, I don’t think I would ever buy a $30k car in the first place. Personally, I’m more concerned about staying out of debt than I am in making money. Peace of mind means a hell of a lot more to me than striking a few extra thousand off of a risky decision that could turn sour in many ways. That’s probably not the way the average millionaire thinks, but I’m not dumb enough to think I have the skills to take risks and come out wealthy. Again, that’s just me.
One rule you failed to mention is the length of the loan vs. the length of utility from the purchase. You should never buy finance something over a period that is longer than the period you are likely to use it. Before you decided that the 4-year car loan is affordable, you need to be sure that the car will still be meeting your expectations in 4 years.