At the time of writing, the Apple iPhone 7 (Black, 32GB) costs Rs. 49,994 at Amazon. Should I pay cash* or pay EMIs over 12 months at an interest rate of 13%? This situation is quite common in life and there are interesting arguments for and against each option that cannot be justified with math. It also offers a chance to understand more aspects of the time value of money. This is part 2 of the "time is money" series.
Before we begin, my book with PV Subramanyam, You Can Be Rich Too is available at a 50% discount (Rs. 198) for short periods of time this month as it was among the top 25 bestsellers in the last 3 months. Grab it now!
Next, Suresh Nayak tells me:
In Google Play , if you pruchase first book they give 75% discount to promote online e book purchase. Subsequent they provide 50% on next book. No code required.
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1) Let us discuss without being preachy and avoid "no need for such an expensive phone", "one should avoid EMIs" type of arguments.
2) * cash also refers to credit card payments if it is paid on time. For now, we will ignore the time is money aspect of that 20-25 days of credit.
3) The mrp of the iPhone 7 is 60,000. So the discount is substantial, probably because there are not many takers. (why do you think there is little or no discount on Remi products!). This discount may not last, (maybe it will!), but we will assume the mrp is 49,994 for this post.
4) The assumption here is that I need an iphone 7 and I need it now. Yes, a need. Not a want. My life and I decide where to draw the line between needs and wants. So there.
Case A: I have Rs. 49,994 ready to spare**. So I go ahead and buy. No question of "investing" this one and buy it a year later. I need it now!
** assuming I have bothered to consider my other needs.
Case B: I can manage Rs. 49,994, but it will take some effort (I have other needs). So I need to know if it is worth the effort arranging the 50K. So it is here the "pay cash vs pay via EMI argument " makes the most sense.
Case C: I can only spare the monthly EMI. Since I need it now, I choose the EMI option, done.
So assuming my situation corresponds to case B, let us consider the EMI option.
At 13% over one year, I need to shell out, Rs. 4465.33 each month. So 53,583.96 over a year. Or Rs. 3,590 extra.
So the cost of not arranging for 50K is Rs. 3,590. But it is not immediate. It is over one year. In other words, had there been a zero-interest loan, the EMI would be Rs. 4,166. So even at an apparently steep 13% loan, I am only paying an EMI of Rs. 4,465.
This means the cost of not paying down cash is only Rs. 299 a month for 12 months. This is not how the loan amortisation works, but to me, this is how it "feels" like. Time value of money at work - psychologically, not mathematically!
From the loan providers point of view, the interest to be paid is highest in the first few months and then it falls off.
They need to be compensated more immediately for the loan that they provided. Again time value of money at work. Even this is appealing to me. I cannot be worried about how high the interest is initially. There is no free lunch and I don't mind dishing out 300 bucks a month (or as per above chart) for not screwing up my cash situation.
Whether I allocate the "extra expense" equally or unequally, the benefit I obtain is the same: an iPhone immediately + the loss is spread over a year + my cash flow is not disrupted too much. In this case, there is no question of pre-payment as that would cost extra (a penalty). In the case of a home loan, the distribution of interest matters, because pre-payment will have an impact on that. But let us not get into that now.
The "What if I invest?" argument
Of course, one can argue that if I invest the EMI amount each month in an arbitrage fund or equity savings funds, I have a decent chance of about 6-7% return after taxes (Quiz: why speak about tax in such funds after one year?).
The problem is that I need to wait one year to get my hands on the iPhone. Why should I? I say that is not delayed gratification, it just a delay. Who is to say I am right or wrong?!
The "Depreciating Asset" argument
One should not take a loan on a depreciating asset, no? I was a fan of this school of thought, but I don't think it is so simple. Be it a car or a phone, they are depreciating assets all right, but it will be ME who is responsible for the depreciation. So as I enjoy the features of a phone or car, it goes down in value. So what?! Let it! Again it is time value of money in a way!
I won't be so sure about the "appreciating asset" argument as well 🙂
I have tried to highlight two issues here:
1) Time is money. We have to pay to instantly enjoy a comfort that we cannot afford to pay in one shot. This is a fair deal to both the lender and borrower, no matter how we account for the interest (cost)
2) Many aspects of finance cannot be entered into an Excel sheet or formula. This post is peppered with some of them.
I did not write this post because I want an iPhone (happy with my Nokia 105), but because I am faced with a similar situation with regard to another purchase. I am still confused if it is a need or want, but that is me. Like I said the confusion never dies!
And in my case, the payment plan is equivalent to an interest rate of 35%(!!). So the amount of interest is 20% of the cash down cost. In the above example, the interest is only 7.2% . So what would you do? Only two options appeal to me emotionally in my case: (a) don't buy or (b) pay upfront. Mathematically^, the EMI option helps me handle my cash flow better. Sigh! Not easy!
^ If I look at the problem from all sides and not just stare at the 35% interest rate! If we want to eat the cake and have it too, we need to pay for both!
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