When to Finance Instead of Paying Cash

Sometimes, cash is the best way to pay for a purchase. Here's when financing makes more sense.

There is wisdom to be found in living below your means, buying only what you can afford, and paying cash whenever possible. Still, financing a purchase can have a place in your life. Here, we'll discuss how to decide when to finance or pay cash.

What is financing?

Financing is when a bank, credit union, or another type of lender lends you money that allows you to make a purchase. You'll typically pay off the loan in equal monthly installments. In addition to any fees charged, you will pay the loan back with interest.

When is it a good idea to finance a purchase?

Financing does, on occasion, make the most sense. Here are a few times financing a purchase is a solid decision:

• When you have unexpected expenses
• When you're buying a home
• When you have an incredible low-interest financing opportunity

We'll go into these in more detail below.

When you have unexpected expenses

Most people have experienced periods when funds were short: a job loss, illness, or another bump in the road. If you need financing, be smart about where you borrow the money and make sure you can afford to repay it.

Some examples:

• You have to pay for medical bills you didn't expect
• You need a loan for moving expenses
• A loved one passes unexpectedly, and financing a funeral is your only option

The silver lining here? Properly managed, financing can help you build a credit history and strong credit score, both of which will benefit you in the future.

When you're buying a home

Few people have enough cash put away to pay for a house. Often, financing is the only option -- and that's okay.

What if you have the cash to buy a house without financing? If you can earn a higher interest rate by investing than you'd pay on your mortgage, you'll save money.

For example, let's say you're going to pay 3% interest on a mortgage, and you'll earn 7% on an investment. If you get a mortgage for the house and invest your cash, you'll earn money (as long as nothing happens to lower the amount you're earning on the investment).

When you have an incredible low-interest financing opportunity

Let's say you need a new lawnmower. You have the cash to pay for it, but a dealer near you is offering 0% financing for 24 months.

As long as you pay the loan off before the promotional period expires, there's no harm in financing. Then, you can put your cash into other investments that allow your money to grow. Even low-risk investments, like CDs, can offer a good return in this situation.

When to pay cash instead of financing

There are a couple ways to determine whether cash or financing is the best option for your purchase. The general rule of thumb we recommend is: Pay cash for non-necessities; finance if you're planning on investing.

Pay cash for non-necessities

A good rule of thumb is to always pay cash for non-necessities. Financing a purchase can be easy and lead you to spend money you don't have.

A night out with friends, Bluetooth headphones, or fabulous new shoes (even if they were on sale) are luxuries. A vehicle that proves to the world that you've "arrived," is also a luxury. If you find yourself doing mental gymnastics to justify a purchase, either pay for it upfront or do without.

Finance if you're planning on investing

Another way to decide whether to pay cash or finance: Ask yourself, "Is the interest rate on financing lower than the rate I could earn by investing?"

Let's imagine you have $1,000 extra cash in a savings account. You go to the store to buy yourself a brand-new dishwasher. Once in the store, you are told you can finance any purchase at 6% interest. You have two choices: Buy the dishwasher in cash, or invest your $1,000 in the stock market and finance the dishwasher. Which do you choose?

The stock market, on average, earns more than 6%. If you finance the dishwasher and invest the cash, you'll likely earn money on your investment. If you buy the dishwasher in cash, you won't pay 6% in interest, but you also won't earn anything on the stock market.

Should I finance or pay cash?

It can be tough to decide when to finance or pay cash, but the trick is to consider what you can afford and what else you might do with that money. The question to ask yourself is whether you could earn a higher interest rate by putting your cash to other uses than you would pay in interest through financing.

Financing can help in emergencies, paying for large purchases, building your credit score, and freeing up money to invest. Cash is still king when it comes to buying non-essentials, keeping track of your monthly budget, and staying out of debt.

Part of deciding when to finance or pay cash is simply about doing the math. Figure out which option most benefits your bottom line. In the end, investing and going into debt are both risks -- so you're the only one who can decide whether to finance or pay cash.