The Low-Interest Debt Debate

A few days ago, I posted an article about our purchase of a 2009 Toyota Prius. One of the elements of the article that got quite a few readers angry was our decision to take out a 4% loan to cover much of the cost of the car, even though we had enough in our car savings to pay for the entire vehicle.

The argument against the loan is pretty simple: debt is bad. By having it, you’re indebted to someone else, condemned to make payments for quite a while or else risk wrecking your credit. Instead, pay cash for everything – no debts, no worries.

I agree with that philosophy to a large extent. Using credit to buy something you couldn’t otherwise afford is an extremely dangerous game. It can bite you hard if life doesn’t go as planned. I know this from experience – in April 2006, I let easy credit almost bankrupt my family due to overspending.

But what if you’ve done things the right way and saved up for a major expense before buying? Is it always the correct choice to make a major purchase simply by writing a check? When you write a check for a major purchase, you’re taking a large amount of liquid cash and investing it in a material item. The ability to use that cash for anything else is now gone (excepting, of course, equity loans, which usually don’t have great interest rates).

Now, at first glance, you seem to gain quite a bit from that exchange. After all, you’re not paying interest on the loan and you’re not required to make a payment every month.

But compare that to the situation where you have all of the money to pay off the debt sitting in a savings account. You can easily earn 2-3% interest on that money just by allowing it to sit there, doing nothing. Thus, the advantage of simply writing a check for your purchase isn’t quite as strong as simply not having to pay the interest on the debt. If you can write a check, for example, to cover a 5% debt, but you can earn 3% by holding onto the money in cash, your dollars and cents benefit is only approximately 2%.

Another factor worth considering is that having extra cash on hand always serves as a supplemental emergency fund. While savings intended for a major purchase should never be juxtaposed with a true emergency fund. having more cash on hand in the event of a major crisis does have value.

There’s also the opportunities that cash provides. If you put all of that money into your purchase and deplete your savings, you no longer have cash available to take advantage of exceptional opportunities.

Here are two examples of what I’m talking about. In late 2006, I made some extra money flipping Nintendo Wiis. I had a good run finding them in stores and I was able to buy them new for $250 and sell them in just a few days for $325. The only problem is that I didn’t have a lot of excess cash to do this – I actually had to do it on credit cards. Because of that, I didn’t want to take a big risk when doing it, so I only flipped one at a time – I’d get the $325 (or so), use it to pay off the debt in full (and use the extra $75 to pay a little more on my debts), then buy another one.

If I had a large bankroll at the time, I could have been flipping these by the armload. I knew where and when to go to get the systems and I also knew where to sell as many as I could get my hands on. I simply didn’t have the capital to do this. If I had, I would have been able to earn a very good return on my money.

Another example: in 2005, I had the chance to buy 72 packs of Magic: the Gathering cards for about $1,500. It was actually part of a much larger lot of trading cards from a shop going out of business. Here’s the catch – these particular packs could be flipped for $200 a pop. Those packs alone would have earned me over $10,000. Unfortunately, money was so tight at the time that I had to pass on the opportunity, even though I knew I could make very good money on the sale.

Exceptional opportunities do come along, and the rewards of those opportunities go to the people who can take advantage of them. Most of the time, that means the people who have easy access to liquid cash.

In the end, my feeling is this: having cash, even if it just sits in a savings account or a CD, is advantageous over putting that cash into a material item. Thus, if you do have the cash to buy an item in full, it’s worth considering keeping the cash and getting a low interest loan for the item.

The key here is low interest. If you cannot secure a loan that’s less than 2% or 3% higher than what you can get in a savings account, you’re better off paying for the item in cash.

That’s my stand on the subject. What do you think?

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