A lot of basic financial planning centers around achieving certain savings goals that culminate in a big purchase. Things like buying a new couch, paying for a wedding, planning a big trip, replacing household appliances, remodeling the kitchen, installing a pool, etc. - ideally you’d have the exact amount of cash on hand to pay for these things at the exact moment you need to close the deal.
And the way many personal finance people tell it, this is the “right” way, or the way people who are “good with money” do it or the way “most people” do it.
I call BS.
I’m not perfect, but I know a lot about how money works and I’ve never personally been in a place where I’ve waited until I had all the cash on hand to make any of the above purchases. Sometimes that was because I had no choice, like the time the front brakes on my Geo Metro rusted to the wheel and my mechanic declared the little death can “unsafe to drive” so I ended up rushing into a lease that I might not have committed to if I’d had more time to plan and save.
Other times, though, it was because I DID have a choice, and I opted for a thing called “leverage” to optimize my money.
Using leverage for a big purchase
For example, let’s take the time we knew our washer and dryer were on the brink and the ones we wanted were on sale at Home Depot, so we went ahead and bought them. We had the cash in savings to pay for them outright, but decided instead to take advantage of HD’s 24 months same as cash offer, giving us two years to pay the balance in full before any interest was charged.
This let us keep our money in savings, earning interest, for up to 2 years longer. The important caveat here is that we had to consider the money spent in order to avoid the risk of not having it when the 2 years was up.
Another example was when my husband and I were still dating and we planned a trip before we’d gotten fully financially naked, so he didn’t know that when he suggested I pay for the lodging while he picked up the airfare that I had less than $1,000 in savings.
To pay for the hotel, I found a 0% credit card and used that to pay for the resort. I didn’t have savings in the bank to make the payments, so I had to add it to my already tight monthly budget. I determined the amount I needed to pay each month by dividing the total amount by the number of months I had the promo rate so that the balance would be gone (or close to it) before the rate expired.
What’s the best way to use leverage?
Deciding whether you should pay cash, use “same as cash” or finance with a loan or credit card, typically comes down to what options you have available.
Cash is king
OK, so I know I said that it’s BS to think you have to have all the money on hand before you buy something, but I didn’t mean that’s not the ideal way to do things. What I mean is that I’m not so far removed from the “rest of the world” to think that it’s realistic for most people to be in that situation, and my role here is to help those who aren’t “financially perfect” still make great money decisions.
If the question you’re asking is whether you can actually afford to buy something when you have some choice in the matter, the answer lies in whether you have the cash on hand to pay for it, not necessarily whether you can afford to make the payment. See, when you opt to use leverage as a strategy to earn interest on your savings longer, it’s only risk-free when you already have the cash in savings to pay the loan off immediately.
In cases where you have no choice, like you HAVE to buy a new refrigerator because your old one died, then the best you may be able to do is find a low or no interest option and do your best to pay it off before interest kicks in.
The ideal situation when using leverage to make a large purchase of something that will be worth less than what you paid would be to set the purchase price aside in a separate savings account and use those funds to pay off the debt you took on at a lower interest rate than you’re earning on savings.
Where “same as cash” deals can go wrong
Buying something with a “same as cash” deal is not the same as using a loan or credit card with a lower promotional rate. That’s because with “same as cash,” the fine print typically says that if any of the balance remains unpaid at the end of the term, then the ENTIRE purchase amount is subject to retroactive interest.
Most people understand that they SHOULD pay it all off when the term expires, but don’t realize that if they don’t, they’ll end up paying interest on the whole thing as if they’d made NO payments. This often catches people by surprise when it’s way too late to do anything about it because they’ve been making the minimum required payments, assuming that they are at least reducing the balance that would be subject to interest if they can’t pay it all off by the time it comes due.
Why a promotional credit card rate might be better
On the other hand, going back to my example above of paying for the vacation with a 0% credit card worked out for me because I was able to make the payments needed each month and had the balance at $0 by the time the rate expired. However, if I had lost my job or had something else come up that had compromised my ability to make the monthly payments, I may have ended up having to pay interest, but only on the amount that was still outstanding rather than the entire original charge from the resort.
In other words, if you’re at all uncertain about your ability to have your balance at $0 by the time any promotional offers expire, you are probably going to be better off using a credit card with a lower interest rate, even if you are offered a 0% “same as cash” deal. That’s because those deals often come with interest rates well over 20% if you carry any balance past the due date.
Things to consider when making your decision
First, if you think there is any chance you’ll end up paying any interest on this purchase, make sure you’re factoring that in to the total purchase price. Our Home Depot laundry machines would have cost us WAY more than the regular price if we had accelerated the purchase due to the sale but didn’t have certainty that we could pay it off in the 2 year time frame.
To figure out how much interest you may have to pay, check out this cost of credit calculator. Then ask yourself, when you add the interest to the amount you’d be paying for the purchase, is it still a good price?
RULE OF THUMB
Finally, anytime you’re considering adding a new monthly payment to your budget, make sure that your total debt payments won’t exceed 36% of your gross income.
For example, if you make $100,000 per year, then you would want to keep your debt payments to $36,000 per year or $3,000 per month, including your mortgage. So if you have a mortgage payment of $2,000 and a student loan payment of $250, and you’re looking to finance a car, you could reasonably afford a $750 per month payment.
In a perfect world, you would never finance something that you couldn’t sell for its purchase price or higher. This is why it’s a financial folly to charge clothes or sushi on a high interest rate credit card if you’re not paying the balance off every month. But in times when debt can’t be avoided, having a plan to pay it off is the best way to avoid getting yourself in financial hot water.
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