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I've heard several people state that they get loans even when they have the money to cover the cost in the bank, and it befuddles me why they would pay interest instead of using their own money.

This seems especially true in small business where I hear people say that business runs on revolving credit.

Why do people choose to pay to use someone else's money when they could use their own?

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7 Answers 7

up vote 27 down vote accepted

There are a few reasons, particularly for businesses.

The first is opportunity cost. That chunk of money they have could be used to get higher returns somewhere else. If they can borrow from a bank at low interest rates to finance their ongoing operations, they can use their cash to get a higher return somewhere else.

The second is credit rating. For public companies, ratings companies give high emphasis to companies with large reserves. This strengthens their ability to pay back the loan should it become necessary. A good credit rating in turn let's the company borrow money at lower rates. When a company can borrow money at low rates, it circles back to the first point where they can now put their reserves to better use.

The third is leverage. Companies can use the cash they have built up to leverage into a larger investment. Assuming the investment works out, it will pay for the cost of borrowing over time. For instance let's say I have $1 million to invest. I can pay all cash for a $1 million apartment building or I can leverage that into a $3 million building. Assuming I run it well, the tenants will pay for the cost of borrowing $2 million and at the end of the term I'll be left with my $3 million building.

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5  
On your third point: this also increases your Return on Assets. In both cases, you've got the same amount of assets, your $1M investment. Say the $1M building nets $100k per year: a 10% ROA. Say the $3M building earns $300k per year: a 30% ROA. Using leverage gives you a higher rate of return per amount invested. –  bstpierre Apr 4 '11 at 1:22
    
Another 'credit rating' bonus: Demonstrating responsible use of revolving credit actually improves your credit rating, even if you wouldn't have needed the credit. –  Arjen Kruithof Apr 4 '11 at 1:49
    
Some entities can occasionally issue really cheap debt, with negative real interest rates (interest rates cheaper than inflation). Microsoft recently issued some bonds at 0.875%; the Fed is targeting inflation near 2%. (Speaking of which, this borrowing helps them pay dividends in the US without paying taxes to bring overseas tax into the US.... this is a whole 'nother can of worms about politics and its unfortunate implications on the capital markets, though, and largely outside the scope of Personal Finance.) –  fennec Apr 5 '11 at 3:37
    
@bstpierre I'm not an accountant, but your math looks wrong. 300k/3M = 10%, not 30%. –  C. Ross Apr 6 '11 at 13:00
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@C. Ross: It's not 300k/3M, it's 300k/1M. Your assets are only the 1M you put in. The other 2M is liability. –  bstpierre Apr 6 '11 at 13:26

Consider the following scenario at a small business:

As a business owner I have 10k in the bank at the moment. I have a one time expense of 4k that will not directly impact the growth of my business. I can choose to pay the 4k out of the 10 in the bank and then put the rest towards business growth. Assuming a 10% annual return on capital at the end of this transaction I am left with $6,600.

Now if instead I chose to pay the 4k with a business credit card I have that only carries a 7.9% interest rate what would happen is that I incur a 4k balance that I have to pay off in a year and put 10k towards my business. Now, this is a simplified case that does not take into account the effective interest on the card and the minimum monthly payments. That being said, what happens in the end of the year is that I owe $4316 to my credit card but I now have 11k in the bank, due to business growth. That leaves me with $6,684 after a year's worth of operations, which is better than my original $6,600.

This is a small scale scenario though, but the basic idea is that if you can put the money towards growth that is better than the interest you are paying to the card, you win. The risks of course include missing a payment and incurring a penalty, not being able to grow your money at the rate you thought, and so on.

Hope this explains things a bit.

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I'm not sure if you are including the use of credit cards in the intent of your quesiton.

However, I will give you some good reasons I use them even when I can pay cash:
1) I get an interest free loan for almost 30 days as long as I don't carry balances.
2) I get a statement detailing where I am spending my money that is helpful for budgeting. I'd never keep track to this level of detail if I were using cash.
3) Many cards offer reward programs that can be used for cash back.
4) It helps maintain my credit rating for those times I NEED to buy something and pay it off over time (car, house, etc.)
5) Not so much an issue for me personally, but for people that live paycheck to paycheck, it might help to time your cash outflows to match up with your inflows.

For a business, I think it is mostly a cash flow issue. That is, in a lot of B2B type businesses customers can pay very slowly (managing their own cash flows). So your revenue can sometimes lag quite a bit behind the expenses that were associated with them (e.g payroll). A business line of credit can smooth out the cash flow, especially for companies that don't have a lot of cash reserves.

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I wasn't thinking credit cards, and generally was referring to situations where you do pay interest of some sort. I certainly understand the advantages of using short term credit when it doesn't cost you anything. –  C. Ross Apr 3 '11 at 20:19

When I put it on the credit card, I haven't paid for the product or service yet. If there is a dispute, then I have the upper hand because the cash is still in my pocket.

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A major reason that I can think of is financial security. Most people have reoccurring costs such as housing, car, medical expenses. If you were to put all you money into dept, and live from check to check, than you could be increasing risk of financial loss. Think about what would happen if one were to default on their mortgage? Risk management plays a huge role in personal finance, and a way of preventing financial loss is to have enough money in an accessible place to pay reoccurring costs in the event that ones situation changes unexpectedly.

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Some reasons I take low-interest loans are:

  • Leverage. If the loan's rate is low enough, then I can invest the cash in something fairly low-risk, and make more money than I pay in interest. The interest rate has to be pretty low, say below 4% or so. My auto loan is low enough and my home loan is low enough if you count the tax deduction. Obviously you have to invest in something riskier than cash here, though. And consider taxes, which lower the rate you're paying on a home loan, but also lower the returns you're getting on any bonds you invest in.

  • Liquidity and flexibility. If I have N thousands in cash instead of tied up in my house, then I could use that money to survive many months of unemployment for example, or handle any other emergency. But if you become unemployed or have some other emergency, it will be too late to get a home loan.

  • Credit rating. It's good to use some credit, just so you can get more if you need it. But this isn't a reason to take a particular loan, just a reason to have some kind of credit card or loan.

  • Budgeting. When budgeting, it's best to think of expenses such as cars and houses in terms of a monthly cost, so you can see how they nudge out or allow other spending. (When negotiating with a car dealer, of course, use total cost so you don't get screwed by him messing with interest rates.) I wouldn't take a loan just to ease the budgeting (you can always manually "amortize") but it's a nice side effect.

  • For credit cards, there are more buyer protections and you get a nice transaction log (again useful in budgeting). Also you don't have to carry around cash, or worry about your checking account balance. So credit cards are just convenient. But even though my card has a very low rate, it isn't low enough that I want to keep a balance month-to-month, so I don't use credit cards to actually borrow money.

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Really basic Revolving credit for individuals.

Use a credit card to pay for a purchase. You pay the card off completely before you pay interest and get 30 days free money.

Your cash balance is for that 30 days doing you some good instead.

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