When you purchase something, there are two ways you can pay.
It doesn't matter what you're buying: a car, a toothbrush, 50 shares of Lockheed Martin stock, or 8,754 toothpicks. There are two ways to pay:
Cash or Credit
When you pay cash you use our own cash flow: the $$$ you have in your pocket, or a direct withdrawal from your checking account with a check or debit card, etc.
When you pay credit, you convince someone to loan you the money and agree to pay them back with interest.
I used to think I could avoid paying interest by paying for things with cash.
But I was wrong.
See, when you pay credit, you have to pay the lender interest. Everyone gets that.
But what people do not consider is that when you pay cash, you give up the interest that you would have made for yourself if you had put your cash to work for you instead.
One of the most valuable lessons I ever learned about money is that paying cash is the most expensive way to pay for something, especially in the long run, for two reasons.
First, because you give up more interest when you pay cash than what you pay up in interest when you pay credit.
Secondly, and most importantly, when you pay cash for something, you lose those dollars forever. They will never work for you and contribute to your overall net worth. And that is where most people lose big time when it comes to money over the course of their life.
Money is what builds passive income, and unless you finance things in a way that grows your money, you will never achieve financial freedom. And paying cash is what hurts that the most.
Let me back up and give you an example of how paying credit can be cheaper.
Let's say you want to buy a car for $10,000. You have the cash to do it, and you decide to just pay cash. No interest, right?
But let's say you can get a $10,000 car loan at 4% interest for 60 months.
Right now you get can a 60 month Certificate of Deposit from a bank at 3.1% compound interest, compounded quarterly. For those who don't know, a CD is simply a bank account with a higher interest rate. You aren't allowed to access your money for 5 years without paying a big fee. You get a higher interest rate by agreeing to not ask for your money back for a period of time.
Let's say that instead of paying cash for your car, you put your $10,000 into a 5-year CD instead at 3.1% interest, and you take out a 5-year loan at 4% interest to buy the car, and the bank agrees to use the CD as collateral instead of the vehicle, so that in the case of a financial hardship you can pay off the car with your own money instead of having to give up the vehicle that you need.
Dumb idea right? You're making less interest than you're paying.
This guy is not very sharp.
But here is where you need two calculators. You need to go find a compound interest calculator, and a loan calculator...because without those you can't see how the math actually works.
If you do the math with the calculators, you will see that since the loan is on a decreasing balance, the total volume of interest you will pay on the car loan over the course of five years is $1,050,
and since the CD is compounding on an increasing balance, you will have made a total of $1,669 on the CD.
You made more interest than you paid, even though the rate of interest seemed to be saying otherwise.
Always look at the volume of interest, not just the rate of interest.
And on top of this, you kept your money and put it to work for you and used someone else's money to pay for your necessity. If you do this consistently throughout the course of your life, you will be able to build great wealth.
O.P.M. = Other People's Money.
If you're anything like me, your jaw may have been on the floor when this sank in.
I never thought of this, and nobody ever taught it to me.
Now instead of giving up that $10,000 forever, you have it in a bank account and it's now worth almost $11,700 and you can do the process all over again. And you have your car, and you paid less for it than you would have if you had paid cash.
There is one huge problem with this strategy, though. Did you notice it already? That's right!
You will get a 1099 on the interest you made on your CD. The government wants in on that action.
And if you financed things like this a lot throughout the course of your life, the amount that taxes would hurt you would be severe.
Taxes destroy the power of compound interest.
Created with images by Rachel Davis - "untitled image" • Jordan Rowland - "Enough for excitement" • Masaaki Komori - "% Baguette Sandwich" • Didgeman - "clock pocket watch gold" • AbsolutVision - "piggybank dollar savings" • Chris Liverani - "Math exam" • JESHOOTS.COM - "untitled image" • Ben White - "The Wonder of a Book" • rawpixel - "untitled image"