Is It Better To Take Out a Loan or Use Your Savings?
Conventional financial advice says you should pay with cash whenever possible. But are there situations where taking out a loan makes more sense?
January 20, 2022
If you have a planned major expense coming up or if a financial emergency strikes, you may need to dip into your savings.
But is using savings the optimal financial decision?
One alternative may be to take out a loan for the expense. Although loans charge interest, there are some situations in which the trade-offs may be worth the added cost.
This article explores the pros and cons of loans and helps you decide whether you should use a loan or your savings.
Using your savings
The process and benefits of using your savings are fairly straightforward. You simply pay for the cost upfront and take funds out of a savings or checking account.
In some cases, you may need to dip into other forms of savings, such as investments, certificates of deposit or savings bonds. This can be a hassle and there may be tax implications if you sell shares. You may be forced to sell at a loss if you happen to have a large expense during a stock market crash or downturn.
Another advantage to using savings as opposed to taking out a loan is that it won’t affect your credit score. And with interest rates on savings accounts at historically low levels — even for high-yield savings accounts — you won’t be missing out on much interest-earning potential.
Pros and cons of using savings
You won’t have to pay interest
You won’t need to go through the loan application process
There will be no effect on your credit score
Savings accounts currently earn very little in interest, so you won’t miss out on much
Avoiding debt helps to instill good financial habits
It won’t affect your debt levels, which should make it easier to get a mortgage or other large loan in the future
Some forms of savings may take time to access, such as investments and bonds
If your savings are invested, you may need to sell at a loss if your timing is unlucky
If your savings are invested, there may be tax implications when you sell
Selling investments means that your money won’t keep growing in the market
It can disrupt your savings goals and financial plans
You can only purchase what you can afford to pay for in cash
Using a loan
Loans require more upfront effort, as you need to apply for — and be approved for — the money.
In many cases, a personal loan or line of credit will be more cost-effective than other types of loans, and you can benefit from their flexibility as they can generally be used for any purpose.
Think of credit cards as a last resort, since their interest rates are very high.
You’ll need to apply for a loan through your bank or another financial institution. If you need the money quickly, it may be best to approach a bank with which you already have a relationship.
Pros and cons of loans
Allows you to keep all your savings and investment plans in place
Allows you to make larger purchases, like a new car
Helps to spread the cost out over time — you make monthly payments instead of a huge upfront payment
You won’t need to sell investments, and therefore won’t trigger a taxable event
In certain cases, there may be tax benefits — for instance, interest on mortgages and business loans may be tax-deductible, however interest on most other loans is not
Interest on loans can add up to a significant added expense
You will need to go through the loan application process
Loans may affect your credit score
Loans enable you to buy more than you can afford, which can lead to long-term debt
Loans can present a significant financial burden for many years to come
Should I take a loan or use my savings?
The answer to this question depends on many factors, including the type of purchase, your savings and investment strategy, and your current debt.
In many cases, it would be wise to use your savings to pay for the expense. This will save you money on interest and help instill good financial habits.
Nonetheless, there are certainly cases where loans make more sense. You’ll need to weigh the pros and cons of loans in your specific situation to be sure.
When are loans a good option to use?
Here are some common situations in which it may be worthwhile to take out a loan instead of using your savings.
When the interest rate is very low. If you have the opportunity to take out a loan with an ultra-low interest rate, this may change the math in favor of getting the loan. For instance, some auto dealerships may offer 0% or 0.99% interest on the purchase of new vehicles from time to time, and home equity line of credit (HELOC) rates can be very low for qualified borrowers who own a home.
When all your savings are invested. If you will be forced to sell investments in order to pay for the expense, you might want to reconsider. If you have made money on the investments, you will owe income tax when you sell. If you have lost money, then selling might be harmful to your long-term investment strategy.
When all your savings are in retirement accounts. Saving for retirement is extremely important. If you’ve been diligent about putting away money in your 401(k) or Roth IRA, the last thing you want to do is pull money out. Plus, early withdrawals from retirement accounts can trigger tax penalties with the IRS.
There are a few exceptions, but it’s generally a good idea to use your savings when facing a large expense — especially if you already have other debt.
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