Should you pay with cash or finance your large purchase?

When trying to decide whether to pay with cash or finance your large purchase, consider these questions.

Have you decided that the time has come to buy a new car? Are you considering buying an RV or doing a big home project? If the answer is yes, at some point, you need to decide whether to pay with cash or take a loan for the purchase. 

When trying to decide whether to pay with cash or finance your large purchase, it can help to consider the following:

What is the interest rate?  

While the rule of thumb used to be to pay with cash whenever possible, this guidance isn’t as straightforward today. If the interest rate for a loan is low (such as 1% financing on car loans), then you might be able to earn more on your cash. In this situation, borrowing may make sense.

Do you have the cash available?  

If you already have cash, and this project will not affect your emergency fund, paying with cash may make sense.

If, however, you will need to dip into your reserves, will you still have enough to cover emergencies? How long will it take you to replenish your reserves? At Hinman Financial Planning, we recommend maintaining an emergency fund of 6-12 months expenses during working years, and as much as 24 months spending once retired. If you are on the higher end of the recommendation, don’t foresee any other large expenses, and can easily replenish your reserves over time, it may make sense to pay cash. If paying in cash means your emergency fund will be near $0, it may be better to finance.

Related story: Understanding Your Net Worth and Cash Flow

If you will need to raise cash by selling investments, there are additional considerations. 

What is the outlook for your investments?  

If the markets are down, it may be best to finance, then sell and pay off the loan after your portfolio recovers. If, on the other hand, your portfolio has done well, and you would like to use some of the gains to help pay for your purchase, then go ahead and sell. Keep in mind that gains often come with tax consequences.

What are the tax implications of selling?  

If you take funds from a personal account, you will have to pay capital gains on the sale of any assets that have increased in value. If you take funds from a retirement account, the withdrawal will usually be taxed as income.

What are the tax implications of financing?  

There can be tax consequences related to financing, too. Interest on home loans may be deductible. Did you know that the interest on some RV’s loans can be deductible as a mortgage interest, as well? If the interest deduction allows you to itemize your taxes instead of taking the standard deduction, it may make sense to finance. 

Related story: Tax Consequences of Renting Out Your Vacation Home

If you are considering using a loan, there are other questions to think about:

How difficult will it be and/or how long will it take to get a loan?  

If time is of the essence, it may be best to pay with cash, then either obtain a loan after-the-fact or use extra cash to replenish your reserves over time. Here’s a quick look at some average loan timelines.

Do you have credit history?  

If you are a widow, have been divorced, or are an inheritor who has little debt, you may not have much in the way of credit history. When this is the case, it may be a good idea to use a loan for a big purchase. 

What are the costs of the loan?

In addition to the interest expense, you should consider other costs associated with the loan. For example, if you are using a home equity line of credit to finance your purchase, you may be required to pay for an appraisal of your home. There may be initial application fees as well as annual fees. These fees will increase the total cost of your loan.

Whether you wish to pay with cash or finance your large purchase, it is a good idea to check in with your financial professional first. We can help you evaluate your options, and ensure the purchase fits with your overall goals and will not derail your plan.