Many of us get hung up on the idea of loans: whether to borrow and/or whether to lend. Some say you should never, ever have any debt. Is that really true?
Today, we’re going to be looking at cash vs. loans, and we’re going to be looking at the extremes. One extreme is Dave Ramsey’s approach. He proposes that you should never, ever have any debt. I’m not saying he’s right or wrong, but it is an extreme approach to borrowing and lending. The other extreme approach would be from Robert Kiyosaki (from Rich Dad, Poor Dad fame) who believes that you should leverage every last dollar in order to make more money. Instead of having everything paid off like Dave Ramsey, he says you should never, ever have anything paid off. That’s an extreme opinion. Is it right? Is it wrong? Or is the truth somewhere in the middle?
We’re going to take a look at purchasing an automobile. I’m using the Truth Concepts software to calculate below what the payment would be if we borrowed $40,000 for a car over a period of 5-years (60 months) with an interest rate of 5%. You can see that the monthly payments would be $754.85:
What would be the actual cost of the vehicle, if you made those payments for the next 5-years? If you would pay $754.85 monthly with a 5% interest rate over 60 months, that $40,000 car would actually cost you $51,334.35:
What if you paid cash for that car? If you were to take $40,0000 out of an account to pay for a car, it’s no longer in your economy and it’s no longer earning you money. This is exactly what Dave Ramsey suggests: Wait, until you have the money, then pay for it in cash. But if you take that $40,000 out, it is no longer making money, and you have to consider the lost opportunity cost of that $40,000. That money now is inside of your automobile, which additionally, has become a depreciating asset. It is not going to make you money. In this calculator, I took $40,000 to pay for the car, your monthly payments are $0 since you don’t have a loan, let’s say you could have earned 5% on that $40,000 over a period of 60 months. Your future value if you had left that $40,000 in your accounts, earning 5%, would be $51,334. Just like if you had made payments of $754.85 over 60 months at 5%, You would also have $51,334.35:
Let’s take a look at the actual math:
$51,334.35
-$40,000 (purchase price)
__________________________________________________
The interest cost to you is $11,334.35.
That cost is either the cost of paying interest or the cost of passing up interest on investments. If you’re looking at the same 5-year period and you can either get charged 5% or you can earn 5%, the end result is exactly the same! Except for this: What is my cost of renting someone else’ money and what could you earn with that money that you’re renting. Whether you are charged interest or you are passing up interest, there is AWAYS a cost to every purchase you make.
If this is a concept you’ve never heard before, perhaps it’s time for you to schedule a Financialoscopy®.
