Finance 101 s4

This presentation compares financing a purchase versus paying cash.

The message is that if financing is used or paying cash, with interest rates and cash flows equal, it will cost the same.

This conclusion is reached in the context of one’s future lifestyle.

If an item is purchased for $30,000, it will cost the future lifestyle $30,000 plus the interest it could have earned.

In this example we are looking at the end of year 5 (60 months).

If we have $30,000 in a tank earning 5%, it will grow to $38,501 at the end of year 5.

If the tank is drained to pay for an item, the tank would need to be refilled so the balance at the end of 5 years is $38,501.

When you think about making a major purchase, you may wonder if you should finance or pay cash. In making a choice, it would help to know which option is better for you financially in the long run. One way to look at the ultimate costs is to calculate what the purchase will do to your long term future lifestyle savings. Let’s explore an example of buying something for $30,000. If you could finance, it over 60 months with a 5% interest rate what will it costs? Likewise, if you paid cash up front, what will it cost you in terms of your long term future lifestyle savings? Which option do you think will cost you the least? And, in addition to looking at costs, are there any other factors you think should be considered in making the decision?

Let’s first look at financing the purchase. We assume that you have $30,000 in the tank and will not use the funds but finance instead. <Space Bar to View 2>

The first step is to borrow $30,000 which is represented by the red area in the Borrowed Funds Tank. <Space Bar to View 3>

Next, let’s look at sixty months of activity. First we see our green tank grow, and see that we use cash flow to pay back the loan and interest. <Space Bar to View 4 – or let all 60 months animate>

At the end of 60 months you can see that your green tank grew to a total of $38,501. Also, you will see that your payments of $566 have paid back the loan in full. So, what did financing cost you? It costs the $30,000 to buy the item, $3,968 in loan interest, and another $4,533 in opportunity costs.This totals $38,501. <Space Bar to View 5>

Now, let’s look at what it will costs to pay cash. Notice that there is the international No Sign in the Borrowed Funds tank. This represents many people’s thoughts on borrowing money. If they have cash, they always pay cash so they are never in debt. When we look at the costs of paying cash, it may surprise you what it costs. <Space Bar to View 6>

So to pay cash, you would need to drain your tank to make the purchase. <Space Bar to View 7>

After your purchase, you would want to fill the tank back up so that you not only replace the $30,000 but also the interest it would have earned over our 60 month example. That will take 60 equal contributions of $566. <Space Bar to View 8 – or let all 60 months animate>

After 60 months, you can see that the $566 in contributions adds up to $33,968. In addition to the $33,968 in your tank, you earned interest and at the end of 60 months the tank will have $38,501.

It’s interesting that both financing and paying cash will ultimately cost your future lifestyle at 60 months a total of $38,501. So if it costs the same either way, why would you ever want to give up control of your money by paying cash? If you could borrow at a rate that is close to what you can earn, keeping your money in the tank gives you more options in other areas of your finances. To be certain, borrowing money requires financial discipline. You must pay the loan back, and you must not over spend because you have kept money in your tank. But with the proper discipline, you may be better off financially and have less stress by financing instead of paying cash.

This solution for this screen is calculated with the following worksheet.

Columns:

Month identifier.

Loan Balance B.O.M. (beginning of month.) Calculated as: (previous month) Loan Balance E.O.M.

Loan Required Payment. Calculated as the TVM payment on a loan with the assumed financing rate (/12 for monthly loan  rate), the assumed term in months and initial cost. Payments are assumed to occur at the end of the month.

Loan Extra Payment (if any).

Loan Interest Paid. Calculated as: [Loan Balance B.O.M.] * monthly loan rate.

Loan Interest Paid C (cumulative.) Calculated as: (previous month) [Loan Interest Paid C] + [Loan Interest Paid].

Loan Principal Paid. Calculated as: [Loan Required Payment] + [Loan Extra Payment] - [Loan Interest Paid].

Loan Balance E.O.M. (end of month.) Calculated as: [Loan Balance B.O.M.] - [Loan Principal Paid].

Opportunity Balance B.O.M. Calculated as: (previous month) Opportunity Balance E.O.M.

Opportunity Contribution. Calculated as: [Inflow] (if Pay Cash) or 0 (if Finance).

Opportunity Interest Earned. Calculated as: [Opportunity Balance B.O.M.] * monthly opportunity rate.

Opportunity Interest Earned C. Calculated as (previous month) [Opportunity Interest Earned C] + [Opportunity Interest Earned].

Opportunity Balance E.O.M. Calculated as: [Opportunity Balance B.O.M.] + [Opportunity Interest Earned] + [Opportunity Contribution]

Inflow. Calculated as: [Loan Required Payment] + [Loan Extra Payment].

Inflow C. Calculated as: (previous month)[Inflow C] + [Inflow]

Outflow. Calculated as: Initial Cost (if Pay Cash month 0) or [Inflow] (if Finance)

Outflow C. Calculated as: (previous month)[Outflow C] + [Outflow]

Lost Opportunity Cost. Calculated as: ((previous month)[Lost Opportunity Cost] + [Outflow C] * monthly opportunity rate) + (previous month)[Lost Opportunity Cost]