When making a purchase, customers can choose to pay for it with cash or use debt financing to cover the price. Debt can come in many different forms: consumers can take out a bank loan, charge it to their credit cards or buy the item on an installment payment plan.
Financing a purchase with debt almost always costs extra money: the bank, the credit card company or the store providing the installment plan charges a fee to the customer for the privilege of not having to pay the entire price with their own cash immediately.
Financial cost of debt
The fee – interest – depends on the loan amount, the interest rate charged and the length of the period over which the loan has to be repaid. The higher the rate and the longer the period, the more money the borrower has to pay back. The total fee paid can be eye-popping for large loan amounts and long periods. A borrower taking out a $100,000 loan at a six percent annual interest rate with a 30-year payback period for financing a home purchase will pay back over double the initial loan: a total of $216,000. The borrower will pay a purchase price of $116,000 for the loan itself.
Obligation
In addition to the high price, debt also imposes a ‘liability’ on the borrower: an obligation to continue to make periodic payments for the duration of the loan. This obligation is contractually binding and can only be abandoned at a very high cost to the borrower’s financial future.
Value and utility
As debt is expensive and seriously constraining, is it worth to assume debt at all and if so, for what purposes? The answer is both simple and complicated.
Buying something with debt is worth it if the overall value of the item exceeds the purchase price and the additional financing costs. However, assigning an actual dollar figure to the value of most things can be complicated, especially for items with a long lifetime or purchases with complex uses and many potential benefits. What is the value of a dishwasher? Is it just the price for which you can sell it? For most people – unless they are in the business of buying and selling dishwashers – that is obviously not the case. It is the overall utility of not having to spend up to a few hours every day doing the dishes plus the potential savings from using less water, less detergent or breaking less expensive china. How many dollars are all of these benefits worth over the few years of the dishwasher’s life? No one knows for sure.
Uncertainty
Even if buyers can assign accurate dollar values to their purchases, it would still be difficult to tell with absolute certainty whether the purchase is worth going into debt. If by some fairy tale miracle a person was offered a magical item whose value was guaranteed to double by the end of the year, would not that make it the best deal ever worth taking out a nice big loan for? Possibly, however, if the buyer-borrower finds himself in a financial difficulty mid-year not able to make debt payments, the deal immediately becomes much less attractive.
Common sense
Most purchase and financing decisions are less miraculous and more down-to-earth. While the average consumer is usually not able or willing to run complex calculations, common sense and simple guidelines can always be applied for the best possible decision. The key questions to ponder will be simple: is this thing worth its price and the added cost of financing and will it be possible and comfortable to repay the debt?
Financing higher education
Some typical scenarios are relatively straightforward. Taking out a loan to finance college education if there are no other resources available for paying for it is usually a wise use of debt, unless it is used to finance a degree with no decent career options. Usually, however, the expected increase in lifetime income more than offsets the price and financing cost of higher education.
Car purchases
Similarly, purchasing a car with debt if the driver has no cash and needs transportation for a new, higher-paying job is worth the extra cost. However, swapping a relatively young, decent, used car for a brand new one that is paid partially with debt may not be the best decision. With a new twist though, swapping the old car for a financed new one may be a great idea if the monthly operating costs of the ancient gas-guzzler more than exceed the new sleek vehicle’s gas, maintenance and financing costs.
Mortgage and leverage
Taking out a mortgage is probably the most significant debt decision most of us will ever make. It is also the most complicated one. It includes so many uncertainties and complexly related factors that even sophisticated computer models cannot reliably capture it.
If there was certainty about the continuous appreciation of property values where they were to continue to rise at a rate equal to or exceeding the interest rate on the mortgage, debt financed home purchases would be an excellent deal with the mortgage providing great leverage.
Leverage – an approach investors and even companies often try to use to achieve high returns – is created when an investor uses debt to cover a portion of the price of a high-yielding investment. As long as the price of the loan remains below the expected increase in the value of the investment, the leveraged investment is profitable.
While leverage for higher returns can be a smart investment idea, for most people it is a gamble, especially for necessities, such as housing. The dark side of leverage is being played out across the US real estate market everywhere: if the value of the financed property not only fails to keep up with the mortgage, but also starts dipping below it, borrowers end up owning more than what their debt-financed purchases are worth.
The purchase of a home is not the right occasion for average Americans to test their financial luck. In general, everyone should decide if home ownership is valuable enough for them given the expected fluctuations in property values and the serious long-term commitment of a mortgage. If it is, they should aim at structuring a purchase where they contribute a large enough, but not too big down payment to give themselves a cushion of equity without pouring all their savings into the transaction and take out a mortgage whose monthly payments they can comfortably afford.
Installment plans
With installment purchases, people often feel comfortable purchasing an item on an installment place by arguing that they would not have the money to pay for the item in one sum, but in ‘twelve easy payments’ they are happy to do it. However, the prospective buyer could consider to convert the twelve easy payments into twelve easy savings targets and purchase the desired item when they finally add up to the price. A loan to bring a purchase a few months or even years forward may not always be worth it.
Credit cards
Finally, anecdotally it is widely known that credit card debt is expensive. With the average annual rate being over 14 percent, $5,000 charged can be paid off with 30 monthly payment of $200 adding $1,000 in financing costs to the original purchase price. Unless the original item was on a 20 percent off sale, it may have been not worth buying a $5,000 item for $6,000.
A good deal
Sometimes, debt can be the optimal choice. A homeowner with an urgent need to replace a broken water heater should opt for a reasonably priced – that is low interest rate – installment plan for the big ticket item even if he or she could afford to pay with cash for the necessary equipment. If the cash is tied up in savings or investments that have a guaranteed return exceeding the financing cost, the installment plan is a prudent decision. However, such great deals are generally far and few in between even in the best of times.
Moderation
The advice for delicious, but calorie-rich foods applies to debt, too: consume it in moderation. Reasonably priced debt can be used for essential purchases having a significant, overall positive impact on the borrower’s life or future, but for products or services of lesser importance it should be used cautiously. If a consumer is not willing to spend cash on it although it would be an option, incurring a loan to finance the purchase is usually not a good idea. After all, when considering a purchase, buying it with cash or debt are not the only options. You can always decide to defer it until you save up enough money or simply forgo it altogether as it is just not that important or not that good a deal.
Additional resources:
Mortgage calculator
Credit card calculator