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I'm trying to better understand the time-value of money and how to compare interest rates vs. investment returns.

In general, if I can pay for something in cash or short-term credit (paid off monthly), I do so. I also try to save up through high-interest savings accounts and diverse investments.

I understand vaguely that some low-interest rate loans are worth paying the interest on, because the money I keep in the meantime can grow through investments. Hypothetical example: if I buy a BigWidget using a loan with 12-month deferred payment then a 2% interest rate for another 24 months, that leaves me with cash to invest and earn 5% return over the 36 months, and then I walk away with more savings than if I just paid for the BigWidet in cash. Is that right?

I also think of inflation being a factor. If an investment has a return of 5% but inflation (increase in my cost of living) is also 5%, I basically got no return, and if that money was saved as cash I would be losing value to inflation. How do loans with fixed interest rates factor into this? In that same scenario, if I could take on a loan with a fixed interest rate of 2.5% for 12 months and inflation is 5% over those 12 months, do I effectively dodge half of the value lost to inflation?

Trying to understand how to best use cash on hand, when I have options to a) invest, b) take favorable loans on spending, or c) simply sit on it as cash.

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    that leaves me with cash to invest and earn 5% return over the 36 months - and what if you lose on the investments?
    – littleadv
    Mar 14, 2023 at 20:56
  • @littleadv fair point, I am assuming that on average investments have some reasonable return, and that I have spare cash to pay the loan back whether the investment does well or not. This question is not so much about large loans, but about relatively smaller purchases (like home improvements) that could either be paid for in a lump sum or through loan installments.
    – cr0
    Mar 14, 2023 at 21:03
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    When purchases like that add up to amount that matters it becomes quite a risk. A one-off purchase of a couple of hundreds will give you arbitrage opportunity that may not be worth the risk, but if you're talking about large amounts then you need to reconsider your budget.
    – littleadv
    Mar 14, 2023 at 21:06
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    @littleadv OP buys a 36 month CD instead of buying an ETF.
    – RonJohn
    Mar 14, 2023 at 21:19
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    Considering only the title of the question, it might be worth taking a loan when buying e.g. a house or an apartment for the only purpose of having the bank also do their due dilligence about it and the seller. Sometimes, they have better info than you. You can pay in full the next month or whatever. Not related to the body of the question, hence not an answer. Mar 16, 2023 at 12:04

7 Answers 7

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In the UK, if you buy something on credit (over £100, under £30,000 if I remember right) then the credit provider is jointly liable with the supplier for the product. If the supplier goes out of business, the bank is still underwriting your warranties.

A few years ago I had solar panels fitted to my house, which cost several thousand pounds. I took the credit offered, because there was no penalty for repaying the loan early. I paid it off after a couple of months (which happened to be easier for me than after the first month).

And the supplier did go bust a couple of years later. There was a 5-year warranty on the inverter, and a 20 year warranty on the panels is still running. The credit company might yet end up paying for replacements if the panels fail.

Usually I would have used my credit card, but back then they would have charged the solar installer a percentage that they'd have insisted I paid. I suspect that the loan company paid them for generating business.

BTW credit card borrowing isn't exactly a "loan", but it's well worth using zero-interest-on-purchases introductory deals. Just make sure you really do put money to cover everything you buy into an interest-bearing account, so you can pay the card off in full when the zero interest period runs out! And you get the same protection against a bankrupt supplier as above.

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  • Out of curiosity, would a lender be liable for the entire cost of the purchase, or merely up to the amount of the outstanding debt (e.g. if one buys a $1000 product with a one-year warranty on a twelve-month zero-interest payment plan, and it fails after six months and the seller is out of business, could a lender simply terminate the loan and keep the $500 already paid, while the buyer keeps the $500 balance to which the lender would otherwise have been entitled)?
    – supercat
    Mar 16, 2023 at 16:11
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    As I understand it, its the cost of honouring the warranty (which may be implied via consumer-orientated legislation rather than explicit). In some cases such as an airline going bust, the liability might exceed the purchase cost. With my solar panels, it would be the cost of making the system function again.
    – nigel222
    Mar 16, 2023 at 16:24
  • Although some credit card companies may offer warranty protections as a perk, it seems rather odd that a lender would be legally required to accept risk beyond the possibility of not being repaid.
    – supercat
    Mar 16, 2023 at 21:58
  • @supercat I'm not sure about loans specifically, but credit card providers are liable for the whole amount, even if you don't pay for the whole thing on the card. E.g., I bought a £6k car - £250 deposit on credit card and the rest cash, but the credit card provider is jointly liable for the whole £6k. I could have paid as little as £0.01 on the credit card, and they'd still be liable for the full amount. It's enshrined in law and called Section 75 if you want to read up more. May 22, 2023 at 15:24
  • @crazyloonybin: Is there any part of the approval mechanism via which a credit card processor would be informed of the amount of liability they're accepting, or would merchant fees be adjusted appropriately?
    – supercat
    May 22, 2023 at 16:00
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Theoretically you can make more on average by investing than borrowing. But there are two HUGE caveats:

In practice, most people are not as good at investing as they think they are. Humans are emotional and irrational, and that often leads to bad investment decisions, not just in what to invest it, but how to deal with losses, when to cut gains, etc. You might be better, or luckier, but that would be the exception, not the norm.

The math also relies on average performance. The stock market is a volatile investment, with returns averaging from -30% to +40% in any given year even in the "safest" equity investments. You can choose less risky investments, but they have lower returns, and before long you're not even making as mush as you're paying on the debt.

In short, it's generally a bad idea to fund risky investments with risk-free debt. Yes you might come out ahead more often than not, but the requirement to pay on the loan regardless of investment performance can multiply losses and in a worst-case scenario lead to a domino effect that causes you to lose everything.

Trying to understand how to best use cash on hand, when I have options to a) invest, b) take favorable loans on spending, or c) simply sit on it as cash.

Inflation is going to happen regardless of what you do with your cash - there's no way to avoid it, only to plan for it. Certainly sitting on cash is not the best option, as you can get even meager returns from very low-risk investments. You will not beat inflation, but if you want to beat inflation you're going to have to take some risk. If you don't need that cash for something, then the best bet is usually to invest at whatever risk level you can tolerate. The general preferred order of using cash is:

  1. Save enough to handle catastrophic emergencies
  2. Pay off all debt except mortgage
  3. Invest for retirement/pay off mortgage/save for college
  4. Invest outside of retirement funds.

There may be other options, like education (investing in yourself) or giving to charities (investing in others), but that's the general idea.

Exactly what you invest in in those cases is a matter of personal preference - are you interested in less passive investments like real estate? Or just let it sit in index funds and grow over time? There's not a "right" answer - only what fits your interests and skills best.

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    +1, one nit: I'd say paying off mortgages and other secured/non-recourse debt should not come before funding retirement
    – littleadv
    Mar 14, 2023 at 21:09
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    @littleadv good point - I put mortgage along side retirement. I would disagree on other debt but I've had that argument on this forum way too much :)
    – D Stanley
    Mar 14, 2023 at 21:41
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    One note on inflation: if your loan rate is fixed, inflation will tend to make it less costly over time. That is, you are paying the same nominal amount but in real-money terms it's cheaper. This is mostly relevant to long-term mortgages. It's part of the reason that a couple years ago when I refinanced my mortgage at a really low rate, I chose to extend it for another 30 years instead of trying pay it off on the original schedule or shorter. I was expecting inflation to increase.
    – JimmyJames
    Mar 15, 2023 at 17:25
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    It doesn't really make it "less costly" - you're paying more interest in the long run. It's just slightly less of a drain on your finances assuming that your income adjusts for inflation also. I don't really use inflation in any kind of financial decisions like these because 1) I can't control or avoid it and 2) it's not directly applicable to individual purchases (it's a broad measure of "price increases" over the entire economy). I'd rather just pay down my debt, save on interest, and free up cash flow sooner.
    – D Stanley
    Mar 15, 2023 at 17:57
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    Warning: They said the same thing about Beanie Babies, and tulips - try this at your own risk.
    – user253751
    Mar 16, 2023 at 0:26
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If you can pay for it in cash, the only reason not to do so is because you are getting better return rates on the money where it is than the loan is charging you -- essentially, a leveraged position.

Example: I could have bought my house for cash. But typical market rate of return is 8%, and when I was buying (just before the credit-swap debacle) mortgage was 6.5%. By borrowing, even after the closing costs, I was making a 1.5% profit in that money I wouldn't have otherwise. (Even so, I chose to pay half the cost in cash, playing it safe.) Later I was able to refinance at 3.25%, meaning that if I got that rate of return from the investments the loaned money was making me a 4.75% profit that I wouldn't have gotten had I paid cash.

Obviously there is the risk that the market tanks. Leverage is more dangerous than straight investing. But used cautiously, as here, the risks can be acceptable. Run the numbers for your expected average case and worst case, then decide whether it makes sense.

Other than that kind of active decision to accept risk, however, if you can afford to pay cash you should be paying cash. Or buying on credit card that you reliably pay off in full every month so you are never paying their obscene loan rates.

Note that in the US, putting at least 20% down as cash will usually let you avoid having to pay for Personal Mortgage Insurance, which is already a significant savings.

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    Primary residence mortgages are probably, in the US, non-recourse, which also limits the risk. General line of credit is usually recourse, so your loss is not limited to the equity in the mortgaged property and it can bankrupt you due to cashflow problems even if you're high net-worth individual. Things have happened, ask SVB.
    – littleadv
    Mar 14, 2023 at 21:08
  • You can check this for yourself but you don't have to beat the interest rate on a loan to come out ahead. For example, if I enter in 200K and a 2% rate for 30 years into an amortization calculator, I get total payments of $266,126. If assume a 2% return on an investment and compound for 30 years, I get an ending balance of $362,272.
    – JimmyJames
    Mar 15, 2023 at 17:46
  • Interesting. Hadn't run the numbers, since as far as I was concerned I was winning with any mortgage under 8%.
    – keshlam
    Mar 15, 2023 at 18:22
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    @keshlam I just thought about it and I made an error. If you assume that the payments go into an investment at the same rate, you actually come out behind with the loan. I might put together an answer that breaks it down. It's hard to explain in comments.
    – JimmyJames
    Mar 15, 2023 at 19:57
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    Even if one would expect to earn slightly less with the money than one pays in interest, one could still come out ahead if one has an unanticipated need for cash during the lifetime of the loan. Conditions that would create a need for cash (e.g. loss of job) would also impair one's ability to borrow money cheaply, but if one took out a low-fixed-rate mortgage beforehand, while putting money that could have been used for the purchase into an earmarked savings account, one could "borrow" money against that account for no cost beyond the foregone earnings on it.
    – supercat
    Mar 16, 2023 at 16:22
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When you get old (like I am) and have paid off your house and have no other loans, and there's a deal on buying a car (say 1.9% financing for 60 months) or furniture (0% financing for N years), then it can make sense to finance the car/furniture even if you don't need to.

The reason is that the credit reporting bureaus (like Equifax) will start dropping your credit rating if the only credit you have is paid off rotating credit card debt.

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  • Is maintaining your credit score the only reason in that case? I guess I'm asking about broader implications
    – cr0
    Mar 15, 2023 at 18:29
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    We had cash to buy our car, but we could see our credit score trending down (and when we looked at the "analysis" on the credit score sites, it was because we didn't have any loans). So, we bought a car, took out a loan (it was a few years ago, with a minimal interest rate, and an incentive from the manufacturer's captive finance company). In particular, my wife's credit score was tanking. We are back at the top of the credit score heap again. So, yes, that was the main reason we do out the loan. We still have the car and we still are paying off the loan.
    – Flydog57
    Mar 15, 2023 at 18:40
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    If you don't have reason to borrow, borrowing just to maintain the credit rating you aren't using is questionable at best. See past answers for debate about that.
    – keshlam
    Mar 15, 2023 at 21:09
  • @keshlam credit scorers want to see some credit usage. Maintaining a small balance on an actively used (so that none of the balance is past the grace period) card is a way to do that. For example, the EOM balance on my main card is $100. FICO and Vantage are happy that I'm responsibly using credit. (I have four, for different purposes, and pay off the other three.)
    – RonJohn
    Mar 16, 2023 at 20:51
  • There is apparently some difference between credit cards and more long term debt. You drop out of the "excellent" category if you don't have both. And, credit ratings are used for other things than credit. Insurance underwriting and employee screenings are both "permissible purposes" under the US Fair Credit Reporting Act.
    – Flydog57
    Mar 16, 2023 at 21:04
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First, you need to be good with money. If you buy an item for £1,000 but don’t pay yet, you must have the mind to understand the money is gone and you can’t spend it anymore, even though it is still in your bank account.

On the other having that £1,000 in your bank account might enable you to take advantage of some good deal that you couldn’t otherwise. You can figure out the finances later. So paying cash might cost you opportunities.

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  • Remember that it is possible to borrow against home equity later.
    – keshlam
    Mar 15, 2023 at 21:07
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If you require cash in the near future or can reliably expect large increases in your income then using a loan is sensible. A loan is also preferred when a fixed interest rate is near or below expected inflation. Loans are great for allowing you to manage your cash flow. Keeping an adequate cash reserve is important for financial health and using a loan to spread out expenditure can allow a reserve to be kept.

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Unless your goal is to gamble, you don't take a loan for something you could pay for in cash unless you have other needs for that cash that you won't be able to get a loan, or as good a loan, for. In particular "take the loan because you'll make more investing the cash" is gambling. You can do that if you like, but you should be aware of all that entails.

So, back to the non-gambling examples where it makes sense. If for example you can buy a house with cash, but then you'd be stuck using credit cards to buy all the furnishings you need, do repairs it needs, etc., you should prefer to take out a mortgage and have the cash to spend.

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  • Agreed, investment is "gambling". Conservative investment on long time scale, however, has a positive expectation value -- you are mostly betting that the economy doesn't collapse completely, and if it does it's uncleared value stored anywhere else will fare better. By all means think it through and understand the system before putting money into it, but don't let the single word make your decision for you. In those terms running a business is gambling too.
    – keshlam
    Mar 15, 2023 at 21:13
  • @keshlam: The rate a bank is loaning money to you at is already based on/comparable to what you can expect from relatively safe investments. If you're going to try to beat that by taking the loan and investing it yourself, you're into real gambling territory. But even positive expected value is still gambling unless the variance is extremely low. And most rational actors would rather get a paycheck than run a business. Mar 16, 2023 at 3:11
  • We agree that we disagree. Achieving market rate of return is pretty darned easy and pretty darned reliable, if you stop trying to beat market rate of return. Even after this past year's churn I'm at a comfortable long-term average of 7% APR, and I am doing nothing complicated, just a small group of index funds, one of each of a core group of very simple types, rebalanced when I happen to think of rebalancing them. It was higher before the war and the correction from the previous few years' unreasonable increases, of course. But that's still enough to make this a relatively safe bet.
    – keshlam
    Mar 16, 2023 at 3:35
  • @keshlam: And only a fraction of a % above mortgage rates. Mar 16, 2023 at 12:23
  • Accepted long-term "market rate of return' is usually quoted as 8%. During the time my mortgage was running, it was well above 8%. Is it guaranteed? No. Is there risk? Yes, and some folks can't tolerate any risk. But the risk can be estimated pretty well, and is reduced if you have a longer time before you need the money and patience to wait out the downswings. "Taking no risk" has its own cost: losing value over time to inflation. Pick your poison.
    – keshlam
    Mar 16, 2023 at 13:41

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