Upfront vs. Investing

What camp are you in?

When it comes to making big purchases, there are two camps. Which are you a part of?

1. Paying for it fully, upfront. These are your “cash in hand, I’ll get you the money tomorrow” kind of people.
2. Financing, or paying in installments. If you don’t have a lot in your bank account, and you live paycheck to paycheck, this is probably you.

Personally, I’ve considered myself the first type. I like to pay for things immediately, and not have to worry about making payments three years from now.

But I heard an aside from someone

2, that changed how I think about it. And it’s monumental if true, but it needs some in-depth exploring. So come along with me, and follow my thought process as we figure this out together.3

Pros and Cons (or so I used to think)

First, we need to start with the traditional benefits and drawbacks of these two approaches. We’ll start with paying upfront.

In short, the biggest drawback is that people don’t have heaps of cash just lying around. But if you do, and you’re careful, seems like a decent idea.

Now let’s talk about financing.

It is kind of nice to not have a massive sum of money just go *poof*, but who knows where you’ll be in two, three, five years from now?

So it’s a toss-up, right? If you’ve got heaps of cash, pay for it now. If not, pay later. What’s this whole article about?

The Big Pro

I haven’t been completely honest in my comparison.

7 There’s another big pro to installments, that I honestly wasn’t aware about until recently. It’s actually kind of funny that I haven’t thought of it, being that I am usually the one people ask in my circles for basic investing advice.8 But maybe it just needed to be re-framed for me to realize how fundamental it is.

Okay, okay. When you pay in installments, that leaves you with all your money still in your account, right? And it lets you earn credit card rewards. But the big thing that I missed is that you can invest the money you haven’t committed yet.

…That’s it? Obviously, if you didn’t spend the money, you can use it for other stuff. So what?

Let me put this another way: You can invest the money (that you will eventually use towards the asset) to earn a return that outpaces the interest costs. You can actually save money by paying in installments!

This idea came from Graham Stephan, a real estate investor and YouTuber, in his video How I Bought A Tesla For $78.

9 He casually mentions that he could earn a bigger return on his money by paying monthly payments and investing his money elsewhere. In another video (which I don’t recall the name of), he says,

Huh. Like I said before, I had never thought of it that way. If, for example, interest rates are 3%, and you invested your money in an index fund that grew 5% every year, you’d make money instead of losing it.

Right?

Why the post isn’t done here

Interest is complicated.

If you’re paying a 5% APR on, say, $100,000, you’re not going to end up paying an additional five percent of the total, or $5,000. APR is the Annual Percentage Rate, and the math is very confusing, but according to a calculator I found online, if your loan has to be repaid in five years, you’ll end up paying $113,227.40, or an additional 13.22740% of the original cost.

So imagine you put that total in a savings account, and pulled your monthly payment from it. By the time the five years are up, would you have extra money? Or would the dwindling cash be unable to keep up with the interest?

It’s easy to say that “3% is smaller than 5%, so you’d make money”, but that is completely ignoring the complexity of compound interest.

10 What we need to do is crunch the numbers, decipher the digits, and figure out if financing is actually worth it.

We need to do some math, and I know you’re just as excited as I am.

11

Cars vs Real Estate

Before we get into it, I do need to address a quick

12 point. All this math will be assuming that the asset you’re financing is stable in value. But in the real world it obviously does matter what you’re putting your money into.

For example, if you bought a brand-new car for $100,000, after 5 years the value will drop by as much as 40%, which means your not-shiny-anymore car will be only worth $60,000, and you will have had a better ROI (Return On Investment) by keeping the money under your mattress.

13141516

In contrast, if you bought a small house for $100,000,

17 and then the market boomed, your house could be worth $300,000 five years later, which would be a 300% increase18. Way better than keeping it in a savings account.

But anyways, we’re going to ignore all that. It’s too much math for one day, and I haven’t even gotten started yet.

The Fun Part

Before, I mentioned that an online calculator told me a $100,000 loan with a 5% APR would total $113,227.40 at the end of 5 years. But how does that math work?

19

If I simply took $100k and multiplied it by 5%, the total is $105k. “Simple Interest” is just that, multiplying the amount by a percentage, multiply that by the amount of years, and bam, you’ve got recurring income in your savings account.

But it’s not that simple.

20 In comes “Compound Interest”, which is when you apply the interest rate to the interest received in addition to the original money (the principal). For example, if you left your $100k in a savings account, and it grew 5% every year, after five years you’d have $127,628.1621.

That still doesn’t match the calculator, however, because unlike in a savings account, you’re not paying 5% on the full amount. You’re only paying 5% on what you haven’t paid off yet.

To simplify, let’s say you had a two year loan on the $100k, and you decided to pay $50k after the first year. After the first year, the interest adds 5%, or $5k, to the loan. Now you pay the $50k, but because of the interest, you’re left with $55k to pay off, instead of $50k. At the end of the second year, you get ready with $55k to pay it off, but the interest hasn’t gone away. Now the remainder has grown 5%, to $57,750. You grudgingly pay the extra $2,750, because what do you know, you’re just a simpleton in a big world of financiers and conglomerations.

If you add it all up, you have paid $107,750 on this loan of $100k, which is an additional 7.75%. See how interest is confusing? And I know that we have calculators to figure this all out for us, but if you can figure it out yourself, it helps to make it a little less like magic,

22 and a little more logical.

Sunset

Here’s a picture I took of a cool sunset, because all this math is making my head hurt and I need a break.

Ok, onwards!

Hold On One Second

Wait. I had an idea.

You know what people love more than really cool articles?

A series of really cool articles.

This one has been going on for too long, and engagement

23 is going to tank if it goes any further.24 And if that happens, no-one will know the answer to their pressing investment questions!

So I’ll see you later, in part 2 of this thrillingly interesting article!

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Go to part two of this incredibly captivating series by clicking “next post” on the bottom, or just use this link.

If you were the only person who clicked in the email sign-up “Long Posts” and nothing else, you’ll love this post on Objective vs Subjective Benefits.

But if you hated every second of it, yet somehow made it to the bottom, console yourself with The Motions of NYC.

Let me know in the comments below, on a scale of one to two, how much you loved this article.

Or just complain about how blurry the sunset photo was.

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