Should You Pay Cash Or Borrow For Major Purchases?

If you’ve got a major acquisition coming up you have to decide between taking the money out of savings or investments or borrowing the cash. How do you decide which way to go?

Here’s an email I got recently from a reader that illustrates the dilemma:

I am considering a major purchase for a motor home. I’m talking about ~$250k. I have a portfolio of ~$1.44m. For the last 4 yrs (since the bottom) I’ve been averaging ~10% on my investments per year. The question is should I draw down my nest egg to pay for this new motorhome or take out a 5yr note at 3.5%? I have no debt and never expected to have any again, but the numbers seem to indicate that I’d come out ahead if I borrow the money for the new rig.

Isn’t that a kind of borrowing-to-invest scenario? JW

Notice – JW isn’t asking if it’s smart to invest using borrowed money. He’s asking how best to finance his purchase.  This is a far different question and it can seem like a complicate puzzle. Let’s break it down to find the answer.

1. Are you pulling the money out of the market?

If you are in a situation that is similar to JW, you have to also consider risk and time. JW is right to look at his historical return (10%) vs the cost of the loan (3.5%). But that 10% isn’t guaranteed. In any one year, JW’s portfolio could tank too. His time-frame is only 5 years and that isn’t very long in the stock market. One bad year could really rock his world – in a bad way.

If JW had 10 or 20 years, individual years have less impact on the overall performance because he would have many more years to make up for it. But with only 5 years, he’s taking on a fair amount of risk.

For JW, if he takes the money out of his investments he’ll save that 3.5% – which means he’s guaranteeing himself a 3.5% return if he goes that route. If he takes the loan and keeps his investments intact he can’t count on earning 10% on average. But he doesn’t have to. All he really has to do is make more than 3.5% in the market for it to make sense to borrow. So if you were in JW’s shoes, you’d want to ask yourself the following:

Would you rather earn 3.5% guaranteed or take a chance in the stock market for 5 years with the hope of earning more than 3.5%?

If it was me, I’d probably split the difference. If it was a 10 year time frame, I’d be OK investing but I would make sure to use a balanced approach. If it was 20 or more years, I’d be fine with a greater tilt towards growth.

This part of it is subjective. You have to find your own comfort level of course

2. Are you pulling the money out of the bank?

If you are sitting on cash in the bank you are usually better off using it rather than taking on debt for your purchase. Here’s why. The bank isn’t paying you anything these days. And if you are earning 1% but the loan will cost you 4% – you are obviously better off using your cash and saving that 4%.

3. Feelings….nothing more than……feelings.

Everything I wrote above is objective advice you can use to make a good decision about financing a major expenditure. But you are human and you have feelings. My experience tells me is that people often make these kinds of decisions based more on their feelings than their logic.  There is nothing implicitly wrong with that friend.

Some people just love having a huge balance in the bank and they are willing to earn 1% or less and pay 4% or more. I understand that. I really do. It’s not a good financial move but if you have very strong feelings about this and you can afford this luxury I honestly have no problem with it.

The same goes for people who are willing to carry debt rather than invade their investments. As I stated above, sometimes this is a smart financial move but sometimes the numbers just don’t work. Again, if you are the kind of person who feels better having the investments intact and can afford to take the risk, that’s OK.

Just please make sure that if you are going to allow your emotions to dictate this decision, you are aware of it and you can afford it. As long as those two conditions persist it might be fine to proceed.

Where do you stand? Would you rather make the financing decision based on the numbers, your feelings or a combination of the two?