I was listening to a well known talk radio show the other day. The caller had called in seeking advice on whether or not she should buy a pool. Now, the interesting thing about this call, was that the woman had enough money in savings (on top of an emergency fund and retirement savings) to pay cash for the pool. However, she was asking about taking out a home equity loan to buy the pool.
The radio host pointed out to her that she had enough cash to buy the pool, and after analyzing her situation, it was deemed NOT to be a frivolous purchase. (As in, she could afford it, she wasn't jeopardizing any other financial decisions, and it made sense in her neighborhood as in... it would not overvalue the property).
The woman did not want to use her cash to buy the pool though. She said I’m scared to use up my savings for it. He pointed out to her that by borrowing, she wasn't feeling the same sting emotionally, as she would if she just paid cash for it. She agreed, and pointed out that she was enticed by a very low interest rate.
WHY would you pay interest to someone else when you have been earning interest on your own money? She concluded that she wanted to keep her money more than she wanted to buy that pool. Reminder, if she likes small monthly payments, she could pay cash for the pool, and make small monthly payments back into her interest earning account and rebuild the savings!
I thought I’d draw up a visual on paying interest versus earning interest. I know that I would not have bought my house had I not been able to get a mortgage. It’s a huge purchase. But I’m 10 years into my mortgage, and I did the math the other day. We've paid approximately $138,000 to our mortgage company over the past 10 years. However, my loan balance - because of interest, has only decreased by $36,000. Had I been willing to wait and invest that money, I would have had enough in 10 years to buy a house for cash.
Here is a very smaller comparison. Say you “charge” on credit a $2000 High-def TV. You have no savings and live paycheck to paycheck, which means that you only make minimum payments on that TV. Do you know, I read a study* recently that shows currently interest rates for stellar credit are hovering around 12%. What the heck do you think they are if you have a dent or two on your credit report? My point being, I chose 12% as the credit card interest rate, and 12% as the investment rate of return, too. I have an investment in one mutual fund that had a 3 year return over 16%, so it can be done.
Here is what I found and want to try to show you:
*It will take you 70 months to pay off that $2000 TV making only minimum payments. The actual amount you will have paid is $2786 (principal + interest)
*Investing $40 a month for 70 months at 12% rate of return (compounded monthly) will give you $5,095.48
Translation? You EARN much more when you EARN interest. If you had used the investment instrument to save up the cash for the TV, you would have been able to buy it after only saving for about 3.5 years. (and your actual cash outlay would have only been $1680)
You and I both know the problem. Some people refuse to WAIT for 3.5 years to buy a TV. As long as people are Broke and Impulsive, the credit card companies will keep on winning. Sad.