It doesn’t happen every month but at least once or twice a year you’re faced with the task of purchasing a big-ticket item. It might be a new washer-dryer, new living room furniture or an entertainment center. You’ve decided what you want to buy and how much you’re willing to pay for it but … the question is should you pay cash or use credit? Unfortunately, what financial experts will tell you is that there is no hard and fast answer. The decision to pay cash or to use credit will depend on your finances, whether or not the asset will increase in value and what interest rates are available.
The first thing you should do according to most financial experts is evaluate your personal finances. What’s your household income? Do you have one or two wage earners? Is your income very consistent? How much are you saving for retirement? Do you have a lot of revolving, credit card debt? If your answers to these questions tended to be on the negative side, it would make less sense to buy that big-ticket item in the first place. If you find that you would have trouble financing the purchase, this could create even greater problems going forward.
When financing doesn’t make sense
If you’re eyeing something that’s actually out of your reach financially or beyond your means then financing it just doesn’t make sense. The only time it makes sense to finance a big purchase is if it’s an asset that will grow in value such as your home or an educational degree. The reasoning here is that the asset will ultimately be worth more than what it would cost you plus the interest you paid. And despite what you may have been told, it just doesn’t make sense for most people to pay $500,000 in cash for a home when they could invest that money and get a 6% or 7% rate of return.
Not all are created equal
It’s important to understand that not all loans are created equal. If you were to take out an interest-only loan this can mean that you’re buying a house you truly can’t afford. When you do this, you really don’t own your home. The bank does. While your mortgage loan payment may be low it’s important to remember that you’re spending money every month but not making any progress towards owning your home. In other words you never gain any equity. The better option is to get a loan where every month you’re paying on both the interest and principal.
The conventional wisdom
While conventional wisdom is that you shouldn’t finance any asset that will depreciate such as a car, a vacation or consumables this is not necessarily true these days. Interest rates are at almost all-time lows. It might make good sense to finance that car. If you can find a dealer that will give you 2%, why not take it? This means that if you have a four- or five-year loan, you’re basically financing your purchase at the rate of inflation. For that matter, 0% financing can be had on a number of purchases such as furniture and jewelry or even an automobile. Unfortunately, those mouthwatering rates are typically available only if you have a credit score of 720 or higher.
Paying it off immediately
If you decide it’s not best to finance that big-ticket purchase you might consider using a credit card to buy it and then pay off your balance immediately in place of handing over cash or writing a check. The policies on credit cards vary but there are often advantages to charging a big purchase. In fact, any time you can put a large purchase on a credit card, it’s pretty appealing to do so. When this is the case, you’re simply using the credit card as a sort of payment conduit so that you can pick up points or miles. In addition, some cards offer protection for the purchases you make with them. As an example of this, if you have a credit card with built-in travel insurance you’d probably be better off charging that $5,000 vacation as cash doesn’t come with any of these kinds of protections.
The caveats
If you decide to use your credit card to make a big-ticket purchase there are some caveats to keep in mind. For one thing, don’t max out your card in such a way that it disrupts your everyday cash flow. You could have an utility bill you pay automatically that bounces because putting that big-ticket item on your card put you at your credit limit. In addition, you should try to keep your debt-to-credit ratio at 30% or less to maintain a good credit score. If you’re not familiar with your debt-to-credit ratio it’s simply the amount of debt you’ve used divided by the total amount of credit you have available. For example, if you have $7500 in total credit limits and you’ve charged up $2000, your debt-to-credit ratio would be roughly 26%, which is good. Your debt-to-credit ratio makes up 30% of your credit score so if you were to let it get to 40% or more your credit score could be adversely affected. You need to be careful when charging that big-ticket item as it could put you over the 30%. And of course, you don’t want to put a big purchase on a credit card if you’re already carrying a revolving balance. This can be a slippery slope that ends in serious financial problems. In fact, this is where most people get into trouble – by continuing to use their credit cards when they can barely make the minimum monthly payments required.
If you’d like to learn more about credit scoring and why your credit score is important then here’s a short video from the credit reporting bureau TransUnion you should find of interest.
When it makes more sense to pay cash
There are certain instances where it’s better to pay cash or to write a check then to put the purchase on a credit card. As an example of this, it’s best to pay cash if it would allow you to negotiate a price as with an independent shop or a dealer. You might be able to save 10% or even better on a purchase if you can pay with cash. There are also some institutions or businesses that charge credit card-processing fees. If this is the case, make sure that the miles, points or cash back that you’re earning is more than what these fees will cost you.
In short, the answer to the question of whether to pay cash or to use credit when purchasing a big-ticket item is … it all depends. You need to take stock of your financial situation including how much you currently owe on your credit cards, whether you’re purchasing an asset that will grow in value and what the purchase could do to your credit score. If you do this you’re certain to make a good decision and not one that will come back to haunt you in the months ahead.