Why I Took a Loan When I Could Have Paid Cash
I bet some of you saw the title of this article and thought to yourself, ‘this makes no sense’. Well, I’m glad you are here, because you are about to learn something. Sometimes you have to think a little bit outside of the box in order to make the most of your money. Just like in our post about CDs, where we recommend looking into some options that don’t immediately present themselves, this is a similar idea.
The principle behind this is really the idea of opportunity cost. (This is your queue to go read our post on Opportunity Cost). Let’s say you have $5,000 in savings and you are earning 2.8% interest from a CD you have it invested in. If you have the option to take a subsidized student loan (if you don’t know what makes a loan subsidized, now is a good time to check out our post on Education Loans) and think it’s the responsible thing to pass up the loan and pay cash to your school, you might want to think again. Since a subsidized loan costs you no interest while you are in school, you are better off keeping that money invested and then paying off the loan as soon as you graduate and start getting charged interest. If the interest you are earning from your investment is less than the interest you are paying on the student loan, then it makes sense to take the loan, even if you don’t need to.
This is the case for any kind of loan, provided that you pay it back on schedule and don’t incur any late fees. Let’s say you decide to get braces to fix the number those wisdom teeth did on your pearly whites. You would want to apply the same principle to decide whether to take a loan or dip into savings to pay for it. The only difference in this case is that unsecured loans (check out our post on Types of Loans) tend to have higher interest rates than other types of loans, so it’s more likely that the investment would need to be a higher return investment than a CD, perhaps a stock or mutual fund, in order to make taking a loan worth it.
Another way you could apply this principle is with credit cards. Now, if you are prone to spending to your credit card limits, I urge you not to read on. In fact, I urge you to go and read our post on Credit Cards. If you are someone who uses a credit card like a debit card, then by all means, read on, my friend. I will caution you that applying this principle to credit cards requires a strong level of attentiveness and self regulation. If you are someone who misses deadlines, then this is likely not worth the risk.
If you have made it past all my warnings and are still reading, then here is how you would apply this to credit cards. Some credit cards will offer the first year interest free. If you sign up for one of these cards, you could put all of your monthly expenses on the card and put the money you would normally use to pay your card each month into investments. At the end of the year, you will have earned interest on that money and then when you pay off your interest free credit card balance, you will have the interest earned to show for it.
This is not a license to spend, spend, spend on your interest free credit card and hope you come into a surprise inheritance check before the interest kicks in. I want to stress that in order to pull off this trick, you must, I repeat MUST, have the funds to pay off the card in full before the year ends and the interest begins.