In 2012 I was working in Corporate America at a major asset management company. In the Fall of that year I received a big promotion to a VP role and had to move from Boston to NYC area.
As a part of my transition, I needed to purchase a vehicle in order to travel around my newly acquired sales territory.
So, off I went to the car dealerships to scope out what was available.
Once I found the vehicle I liked and negotiated the price, I was faced with a decision – should I pay cash, or should I finance the purchase?
UNDERSTANDING THE LONG-TERM IMPACT OF YOUR FINANCIAL CHOICES
In a situation like buying a car, most people focus the bulk of their efforts on the purchase price. This is absolutely important, and it’s a great way for you to lower the total cost of one of the biggest purchases of your life.
But once you’ve finalized that point, it isn’t time to let up.
In fact, decisions like choosing between paying cash and financing a purchase will have both a short-term and long-term impact on your finances.
The question is, which should you put more emphasis on: Long-term or short-term?
WHY YOU SHOULD FOCUS ON YOUR SHORT-TERM FINANCES EARLY IN LIFE
The quick answer most might give to this question is that you should make the decision that maximizes your long-term wealth.
By not taking out a loan, you won’t have to pay any interest, and therefore, the total purchase price of your vehicle will stay as low as possible (not accruing additional interest over the years). Making these types of decisions throughout your life will certainly have a positive effect on your wealth-building, by keeping the cost of purchases to a minimum.
But this mindset misses a couple key points for most people.
- Many young adults might not have the full purchase price of a vehicle to spend.
- In the early years of your career, it’s important to build up a strong financial foundation, which will help you develop what I call a larger financial “Boat.” This can be accomplished by minimizing your financial outlays, and maintaining as much liquidity as possible.
If you aren’t earning an extremely high salary, it can be difficult to accomplish this if you keep paying for large purchases all in cash.
WHY KEEPING SHORT-TERM COSTS LOW WILL HELP YOU BUILD A BIGGER FINANCIAL “BOAT”
In the early years of your wealth-building, you might be sitting there with very few assets.
Maybe you have a decent income, and maybe you have a few dollars lying around; but you don’t have much in terms of wealth.
At the time of my vehicle purchase, I had a decent chunk of money saved up. The purchase price of my car was about $25,000. I could have paid for it in cash, but I chose to finance the purchase with an auto-loan. At the time, the dealership was offering rates of 0.9% APR, with little money down.
The car payment came out to around $480/month, which meant that in that first year, I would pay close to $6,000 in car payments, as opposed to the $25,000 outlay if I had purchased in cash.
This decision allowed me to keep $19,000 liquid in that first year, giving me a lot more financial resiliency in the event of an emergency.
Also, the 0.9% APR was incredibly low. So, even over the course of a 5-6-year loan, the amount of interest would be negligible.
Keeping myself liquid allowed me to continue to invest a substantial amount of my earnings into long-term investments, and make decisions based off of analysis, not fear.
ANOTHER EXAMPLE OF KEEPING SHORT-TERM COSTS LOW
Another big purchase people don’t typically think about in short-term vs long-term costs is a home purchase.
When you are deciding how to purchase your home, this is the moment of truth in which you are making this decision.
There are many different types of mortgages, ranging from fixed, to variable, 30-year, 15-year, and more. If we look at just three, we can see the trade-off I’m talking about.
If you buy your home for cash, you won’t pay any interest at all. That is clearly the best way to make sure you are minimizing your all-in cost.
If you use a 15-year mortgage, you’ll pay interest, but it will be over the course of half of a 30-year mortgage.
But, the benefit to using a 30-year mortgage is that you will have the lowest monthly payment. This will allow you to keep more money in your pocket each month, allowing you to maintain a higher level of financial resiliency (think: higher savings = more ability to deal with shocks).
Once you have built up a solid level of wealth – including an emergency fund, savings, and some investments (How To Create Passive Income And Stop Working), you can begin pumping more money into your mortgage payments each month and pay down your loan faster.
DON’T SQUANDER YOUR OPPORTUNITY BY SPENDING THE DIFFERENCE
Here’s the BIG caveat, and where most people trip up.
If someone is keeping monthly expenditures low in hopes of saving up more money, they need to actually follow through on the saving of that spread between their income and expenses. If you keep your monthly costs low, but just end up spending the difference, then it’s pointless.
You would have been better off just paying in cash (or as fast as possible) and avoiding the additional interest.
DON’T SPEND SMALL AMOUNTS ON SOMETHING YOU DON’T NEED AT ALL
Also, if there is something that you just don’t need to be purchasing, whatsoever, then the debate between long-term vs short-term cost isn’t one you should even be considering.
Author and business consultant, Peter Drucker once said:
“There is surely nothing quite so useless as doing with great efficiency what should not be done at all.” – Peter Drucker
In that same vein, if you are trying to figure out the best way to purchase something, but it’s something that you shouldn’t be purchasing at all, then you need to reconsider the entire exercise.
Don’t do something well that shouldn’t be done at all…
TRANSITION YOUR FOCUS OVER TIME
So, now that you understand the trade-off between optimizing the long-term cost of a product vs. minimizing the short-term impact it has on your finances, it’s important to understand when to make the transition.
In those earlier years, you need to minimize the short-term costs so you can begin building your financial “boat.”
Once you’ve hit certain milestones, like saving up an adequate emergency fund, building up an investment portfolio, and diversifying your streams of income, then you can begin focusing on the lifetime cost of each purchase.
At this point, you’ll be in great shape, and you’ll really begin to see your wealth-building take off!