It’s generally accepted that if you have the cash to make a purchase, you should use it, instead of going into debt by financing that big-ticket item. But is the cash-is-king rule universally true?
Yes, broadly speaking, you’re better off paying cash than financing at high rates of interest. But if the cost to finance a purchase is lower than the return you think you may receive by investing the money, things become less clear-cut.
Taking Your Money for a Drive
Let’s look at a common scenario: the purchase of a car with a list price of, say, $20,000. If you were fortunate enough to have that amount in cash, you could skip the financing, own the car free and clear, and best of all, have no monthly payment.
But some manufacturers offer extremely low interest rates to finance their cars—sometimes as low as 0%. What if you were offered a 2.5% rate and, instead of paying cash, financed the car, then took your $20,000 and invested it? If your investment returned more than 2.5% annually over the course of the loan, it would make more sense to finance than to purchase. Of course it's not an apples to apples comparison, as the 2.5% from the debt is known, and the investment may make more or less than 2.5%, and that is before we consider transaction costs and more importantly taxes.
What if the dealer offers a choice between a rebate and a lower percentage rate on a loan? The same logic applies; you just need to solve a simple math problem to determine the opportunity cost of the rebate versus the reduced-rate loan.
But what happens if you already have outstanding debt? Should you take any extra monthly cash you have and pay it down, or use it to invest?
Targeting Your Debt
For any debt that has a high interest rate, we commonly hear it’s a good idea to use your excess cash to pay it off before investing. One effective way to do this is to organize all your debt from highest interest rate to lowest, then take a targeted approach.
Suppose you pay the minimum amount due on every debt obligation except for the one with the highest rate. For that one, you pay the minimum and then put all available extra cash toward the principal. Once that debt is paid off, you take the same approach with next highest interest rate debt, and so on, until you only hold debt with interest rates where this approach may not make sense, such as a home mortgage.
Many factors come into play when considering whether to pay down your mortgage: risk tolerance, ability to save, tax rate, credit history, and so on. But aside from a short period in the early 1980s when interest rates were at all-time highs, investment returns have generally exceeded the net effective mortgage rate for borrowers. Keep in mind that calculating that "effective rate" can become confusing once we consider the tax deductibility of a mortgage. That is one more reason to be sure to consult your tax advisor when making any of these decisions with a tax aspect.
Financial decision-making can be complicated, and can involve a number of variables, assumptions, and costs—including money, time, and opportunity. But savvy shoppers and savvy investors understand how important it can be to do the math.