In this age of instant gratification -- especially among the young and salaried (Gen Y) individuals -- buying a big budget item is almost hassle-free. They can easily be bought with little to no down payment and banks and other financial firms line up with attractive offers and EMIs that are sometimes too hard to ignore.
However, to reach an objective conclusion between the choice of saving now to buy a big budget asset later, over buying something right away on EMIs, one needs to evaluate various pros and cons regarding the purchase.
First and foremost is the differentiation between want and need: If you want something, then, in most cases, you have the luxury of time to plan and save for the same; on the other hand, if the item you are planning on buying is an actual and immediate need, then buying the item upfront with cash or financing it's purchase and paying an EMI is a feasible option.
Besides the fact that buying an asset through loans increases your indebtness, there are other important factors or situations that occur due to buying on loans:
Added financial obligation: Financing through EMI results in creating long-term debt and commitments which, if not honored, can cause problems.
Extra cost to be paid: Every EMI has two parts, principle and the interest; the interest part is extra cost that one has to pay to own an asset. The longer the duration of the loan, the higher is the cost of acquisition of the asset.
Opportunity cost: Owning an asset through financing does entail an opportunity cost in the form of the interest one pays in owning the asset. In doing that, one forgoes the opportunity to invest the same amount and earn interest and generate income
Losing financial freedom: Having to pay a certain amount every month towards an existing EMI leads to loss in financial freedom; not paying or delaying payments leads to fines and fees and negatively impacts one's credit history, thereby restricting access to credit in the future or during emergencies. Once in debt, all the financial planning for one's free cash flow after basic expenses is focused on first paying of the debt, therefore restricting one's legroom for making financial decisions.
The economic sense to buy an asset only after saving for it, rather than buying it through a loan, can be better understood through an example. The basic assumption is that the big budget item that one is planning on buying is not an immediate need and the buyer has at-least two to three years to plan and save for the purchase.
It can thus be seen that the effective cost that one pays through the EMI route is almost 30 per cent higher than the scenario in which one first saves and then buys. The primary reason for this difference is that in the first cast one is spending money as interest on the loan whereas in the second case one is accruing interest thereby reducing his/her cost of acquisition.
The example clearly establishes that saving first and then buying a big-ticket item is always a better option as opposed to taking a loan and buying it right away.
One, of course, will be denied the pleasure of instant gratification and would have to wait to own the asset; but at the same time, the savings thus realised are significant and can be used to buy a smaller item or can be used for other productive purposes at zero upfront cost. This further reinforces the fact that postponing expenses creates wealth, whereas advancing the date of their purchase leads to erosion of wealth. This basic personal finance tip can help individuals build long-term wealth through small steps.
(Rahul Agarwal is Director Wealth Discovery/EZ Wealth. The views expressed are personal)