Wednesday, May 12, 2010

Spend Less Earlier or More Later

For large purchases such as furniture, car or house, financial decisions are sometimes based on the size of the monthly payment. If the amount is affordable, then the purchase is made using monthly payments for a specific period. Personally, I like to evaluate the total cost when determining whether to make a purchase with cash or over time. Below are a two examples of the difference between paying immediately or over time.

Home Mortgage @ 5.375% interest rate
PricePayment PeriodTotal Spent Difference
$150,00030 years$302,384$152,384
$150,00015 years$218,826$68,826
$150,00010 years$194,234$44,234

Car Purchase @ 10% interest rate
PricePayment PeriodTotal Spent Difference
$25,0007 years$34,862$9,862
$25,0005 years$31,870$6,870
$25,0003 years$29,040$4,040

Essentially, the value in the difference column is the price for "paying later," which range from 16% to 102% of the money borrowed. For purchases other than a home, the premium for paying later isn't worth it to me and I try to pay cash immediately. For a home, our approach is to take out a 30 year fixed rate mortgage, but then try to pay it off as soon as possible, to minimize the difference in cost.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2010 Achievement Catalyst, LLC


Anonymous said...

Did you adjust for inflation? If so, what inflation rate did you assume?

Anonymous said...

Well, did you??

Super Saver said...

@ Anonymous,

I didn't adjust for inflation or deductibility on tax returns in the calculations. The total spent is just a sum of the monthly payments.

Rex said...

Would love to see this adjusted for inflation, it's a calculation you rarely ever see and it makes me wonder what kind of effect inflation has on these prices. For example if you have a $1,500 payment now and a $1,500 payment 25 years from now, the payment 25 years from now may be next to nothing. For example a $1000 payment in 1985 would be $488.65 after inflation (source:

Super Saver said...

@ Rex,

I agree that adjusting for inflation makes the sum of payments less in constant dollars. However, if the interest charged is higher than inflation, the sum of payments should still be higher than a one time payment, even adjusting for inflation. On the other hand, if inflation is expected to be above the interest rate for a while, then the sum of payments would be less than a one time payment, in constant dollars. The challenge is accurately predicting when and how long inflation will be above the interest rate :-)

Anonymous said...

Yes, it's challenging to predict future inflation rates. But predicting zero inflation (which is effectively what you've done) isn't realistic, and it makes your conclusions pretty suspect. Take that home mortgage at 5.375% - a 3% inflation rate would *really* take a chunk out of the 102% "price for paying later." And if you take the lump sum you would have spent on the house, and invest it in something that earns more than 5.375%, you could actually come out ahead.

Super Saver said...

@ Anonymous,

Adjusting for 3% inflation yields a real interest rate of 2.375%. At that rate the total payments are still about 40% higher than the price. That is still a higher premium than I am willing to pay nowadays.

I agree that investing the cash and earning more than the interest rate can be a good strategy. However, it is not a sure thing, as the economic crisis has shown. On the other hand, paying off a mortgage has a guaranteed return.