Summary: Should I Pay Cash?
As a young professional, you are faced with a myriad of decisions when it comes to managing your personal finances. Should you buy or rent, tackle your student loan or car loan first, invest or pay off debt, pay cash or finance? While these might sound like relatively straightforward decisions, we occasionally fail to account for the true cost of what we are giving up by forgoing alternative choices. This invisible cost is referred to as opportunity cost, and if we don’t pay adequate attention to it, it can erode a significant portion of our potential wealth over our lifetime, particularly when it comes to ignoring the hidden cost of paying cash.
Opportunity Cost Defined
Opportunity cost can be defined as the value lost as a result of choosing one option out of two or more available alternatives. When it comes to personal finance, one of the areas where opportunity cost is most prevalent is when we pay cash for major purchases. Whether it’s from books, blogs or well-intentioned advice from parents and peers, many of us have been conditioned to believe that paying cash is the “cheapest” payment method as we avoid an interest payment. While this advice sounds logical on the surface, lurking invisibly below the surface is the fact that while we may be avoiding an interest payment by paying cash, we are still incurring an interest cost – in other words, opportunity cost.
Understanding the Hidden Cost of Paying Cash
Given most of us will purchase vehicles throughout our lifetime, let’s look at a simple example of paying cash for cars.
Take Rachel for example. We’ll assume she starts with nothing, saves $10,000 at the beginning of each year and earns a 5% net rate of return over 30 years. A simple future value calculation tells us Rachel would have $697,608 at the end of 30 years. However, Rachel wants to buy cars, and she decides every five years, starting in the fifth year, she will pay cash for a $50,000 car. Throughout this 30 year period, Rachel will end up buying six cars, spending $300,000 in total. At the end of the 30 year period, how much does she have left? At first thought, most people will answer that Rachel will have $397,608, $300,000 less than if she had not purchased the cars. But the fact is she will only have $66,361 left after 30 years. So what happened to the remaining $331,247? Rachel has fallen victim to one of the most common blind spots in personal finance, and her $300,000 of cars actually cost her $631,247 when you factor in the cost of her cars plus the opportunity cost incurred. To Rachel, it was obvious that she was avoiding an interest payment which is why she decided to pay cash in the first place, but what wasn’t so obvious was that she was still incurring an interest cost – the foregone investment growth she could have earned on her capital had she not used it to purchase cars.
You Finance Everything You Buy
While it’s easy to understand how the idea of avoiding an interest payment can tempt us to pay cash, it’s important to look at the big picture and to consider the foregone investment growth as a result of that decision. While opportunity cost may be invisible, it is a very real cost that can’t be ignored. Just because we have the ability to pay cash doesn’t mean we should. As Nelson Nash says in his book Becoming Your Own Banker, “You finance everything you buy – you either pay interest to someone else or you give up interest you could have earned otherwise”.
There are certain things that once seen, you can’t unsee. Now that you recognize the hidden cost of paying cash, my hope is that you won’t be able to help but evaluate your major purchase decisions through this lens going forward.
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