If you borrow money from a lender that lender finances your purchase and you pay interest to the lender for the privilege of using their money. If you pay cash, YOU finance it. You save interest that would have been paid to the lender, but you lose the interest that the cash would have earned if you invested it elsewhere.
Why do those who pay cash for major capital purchases do so? Let’s start with what a major capital purchase is. We’ll define a major capital purchase as anything that you need to buy or want to buy in your current lifestyle that you cannot afford to pay for in full with your monthly cash flow.
The two primary reasons people give for paying cash are:
- Saving interest
- No monthly payments
The cost of an item is the cost regardless of how you choose to pay for it. Let me illustrate what I mean with an example. If you had $30,000 to invest and you could earn 5.00% on your money over a 5 year period of time, at the end of 5 years your investment would grow to $38,501. The $8,501 is the interest your money earned. Now let’s say instead of investing that $30,000 you decided to pay cash for a car. Did you save interest by paying cash? The answer is yes. However, you gave up the $8,501 in interest that you could have earned.
What would you have paid if you chose to finance the purchase of the car instead? If you could obtain financing at 5.00% for 5 years, your payment would be $566.14 per month. At the end of 5 years, you would have paid back $33,968 ($566.14 x 60 = $33,968). That is the original $30,000 you borrowed plus $3,968 in interest over that 5 years.
You gave up $8,501 in interest to avoid paying $3,986 in interest. Why is there a difference between the interest you earned ($8,501) on the $30,000 you invested and the interest you paid ($3,968) on the $30,000 you borrowed? Compound interest versus simple interest.
To determine if paying cash is for you, click here to download our white paper entitled “Is Paying Cash Detrimental to Your Financial Profile?”
If you’d like to understand more about how you may be affected by this or discuss other options that may exist for you please contact us at (619)994-1110.
Before any major capital purchase there are many things to consider such as the true cost of the item, opportunity cost, the impact of how you intend to pay for it, inflation, and many others.
For instance, as a result of the impact of inflation, when you pay cash for major capital purchases you are giving away your most valuable dollars today so, in effect, the item is costing you more than if you made payments with dollars that are worth less and less over time.