Beyond Interest - The Real Cost of Borrowing

Most of us are familiar with interest rates and their impact on our purchasing power. If you’re not, here’s an example from How often have you been warned about "buy now pay later" schemes, putting a purchase on your credit card, paying for something using your line of credit, store credit or, worst of all, payday loans? Various permutations of these options are out there are ready to "help you" get what you want or need now as opposed to waiting until you have the cash in hand to make the purchase. The result is that like for like, you end up paying far more for a purchase when you buy it on credit than buying it outright.

There's more to it than the cost of interest itself. Buying on credit can cost you in other ways:

  1. It usually means buying something new, which leads you to overpay (you are the one paying most of the depreciation on the item).
  2. It reduces your negotiation power by breaking the overall cost down into a non-negotiable payment schedule, which masks the item’s true cost.
  3. It can lead you to buy more than you would otherwise.
  4. You may enjoy consumable goods and experiences less because you didn’t prepay.
  5. The purchase may mean less to you because you didn’t give yourself time to anticipate it and work for it.

Are you skeptical? Here is each point in more detail.

1. The Cost of Buying New

Most consumable goods depreciate and they depreciate most in the first 1-3 years of ownership. A computer depreciates by 50% in the first year. A car, 11% as soon as you drive it off the lot and 20% yearly on average during the first 5 years; other goods, 50-80+% in the first year. You are also guaranteed to have to pay sales tax which in many cases is not applicable hen purchasing a used asset in a private sale setting. That is a hefty price to pay for the privilege of owning a brand new product. Why not buy a used version of what you want, one you can afford outright because you let someone else deal with the depreciation cost.

2. Lost Negotiation Power

Car sales is an easy target for this one because of the way they are usually marketed. Unless you own a business, leasing is an automatic no go. It is easy feel you are getting more car for your money and emotions can take over when you only consider the monthly payment, ignoring the fact that you will have no car upon termination of the lease agreement. There is also less room to negotiate when the lease offers are set by the manufacturer as opposed to the dealer. So buying is a better option, right? Yes, but only because the car is yours to keep once you have completed the payments...and that is if you can resist longer and longer payment terms. Car loans can now extend to 8 years and each additional year means more time for interest costs to work against you. And what about 0% interest rate financing? If you are paying cash, you will get more bang for your buck by having more potential to negotiate a better price. Of course, it would be a good idea to compare what you are saving paying in cash with what you could make in investment income with the money - but only if you would actually invest it! With 0% financing, you will also have to resist getting talked into upgrading to a car that eats up the “savings” of not paying interest. Extra car means extra cost and extra depreciation too.   

3. Sleeping On It Reduces Total Consumption

Being able to immediately pay for goods and services can lead us to more frequently buy on impulse. The danger with buying on impulse is that it is an emotional decision as opposed to one that has been properly considered, which can mean:

  • buying something you don’t really want, 
  • upgrading a purchase to a more expensive option or 
  • buying multiples of something when you only needed one. 

Impulse buys are often the ones we regret later because we could have made better use of the money, such as using it in a way that supports our longer term goals.

4. Prepaying Increases Enjoyment

Paying after you have acquired an item is a double-edged sword. Yes, you get to have it sooner, but every time you use it, you know it’s not yours. If something happens, such as a job loss or property damage, it can become a burden, or worse, it can be repossessed and you are left paying for something you no longer own! That nagging feeling never leaves until the debt is erased. You just don't feel the same way about using a good that is rented or purchased with credit compared to enjoying something you own outright. 

Prepaying also lessens buyer’s remorse. The longer in advance you pay for an item or an experience, the more you enjoy it. The sting of the personal cost (aka the price you paid) was incurred in the past. All that is left is for you to enjoy what is rightfully yours and you manage to get more out of the experience because there is no point feeling guilty about what you have bought and paid was done long ago, by your past self. Of course, that only works if it is already paid in full. You can't get that great feeling if you "paid" for it and it's still on your line of credit or credit card.

5. Anticipation Is (Over) Half the Fun

Two things happen when we feel we can buy anything anytime on credit: 

  • We don't enjoy making the purchase as much as we could because there is little time to feel the excitement and anticipation of fulfilling the desire. If you want to get a new coat and you go get it on impulse the same day, it’s not really an event. However, if you wait for it and imagine the benefits you will derive from it you enjoy it more when you do finally purchase it. Did Christmas come to mind?  
  • We do not have to "work for it". If you scrimp and save your dollars to get something you want, say a car, you really appreciate it. What you have purchased or acquired becomes a symbol of your hard work and diligence. It means more to you than it possibly could otherwise.

Based on the above, it is more likely that those who have a spending deficit get more value out of what they buy. And that that value goes well beyond the savings associated with the time value of money. 

So here’s the short formula to keep in mind for future purchases: 


Is using less credit worth it? Can you afford not to? Tell me what you think.


Abacus image courtesy of Stock Monkeys.