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How to finance a major purchase

At a glance:

Some ways of paying for big purchases may be more cost-effective than others. Saving up funds through budgeting is often the first choice to consider. But you can also invest in the markets, and you can take out various loans. Here we will look at the major options for you.

How to budget for a major purchase

The first step in (responsibly) financing a major purchase is to establish a household budget. That way, you can see how and where the planned purchase can be fit into your overall financial picture. In a nutshell, budgeting is simply the process of balancing monthly cash inflows with expenses.

Inflows and expenses can be looked at several ways

For most of us, cash inflows are predictable—typically, a paycheck. Expenses may be fixed (e.g., house payment or rent) or variable (e.g., entertainment or "pocket money"). These examples of expenses may also be characterized as discretionary or non-discretionary: You can choose to spend on a night at the movies, but have no choice about paying your mortgage.

A major purchase, by its nature, is a variable expense—we don't need a new roof every month. But it is important to recognize whether a big purchase is discretionary or not. When the refrigerator dies, we need a new one immediately, but the 48-inch TV can wait.

Try this exercise

For a month, carefully record your cash inflows and expenses (especially the latter). This overview will help to project future cash-flow needs and suggest which expenses can be targeted for cutback, if need be.

The point of this exercise, as most financial advisors agree, is to "find" dollars that you can "pay yourself first." Paying yourself first means setting aside and saving a certain amount of money from your gross income on a regular basis.

Paying cash for everything we buy is clearly a good way to avoid becoming burdened by debt. Unfortunately, however, the dead refrigerator or a hole in the roof demands immediate attention, whether or not funds are available out of pocket. So you will also need to examine the use of borrowed funds for financing a major purchase.

Leveraging automatic savings and investment plans

The most painless way to "pay yourself first" is to set up an automatic savings program. Consider having regularly scheduled withdrawals made from an existing account (e.g., the checking account where your paycheck is deposited) and transferred into a dedicated savings or investment account. Generally, any financial services institution that offers savings or investment accounts will offer an automatic savings plan.

Experts recommend creating an emergency fund as a first savings priority; three to six months' living expenses is a rule-of-thumb goal. Ideally, this is where you would turn for that new refrigerator tomorrow.

Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., January 15, 2020. REUTERS/Brendan McDermid
Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., January 15, 2020. (REUTERS/Brendan McDermid)

Appropriate investments for major purchases

Especially if you don't have a high tolerance for risk, certificates of deposit or money market funds are good savings vehicles for major purchases. A money market fund invests in low-risk securities such as Treasury bills. These funds are managed to provide a low return, but more importantly, to maintain a stable value.

Because money market funds are highly liquid (meaning they can be converted to cash quickly without investment), they are also well-suited for your emergency fund. After all, when you need money in a pinch, you must access it without regard for prevailing conditions in the financial markets that day.

When income investments make sense

Income investments are a reasonable alternative to money market funds in saving for a major purchase. They provide steady interest or dividend payments. (Interest is paid on debt investments such as bonds. Dividends come from the earnings that equity or mutual fund investments make.)

The most well-known advantage is that the income investor—unlike the growth investor—receives money now. Because of the regular income stream, the underlying value of an income investment will tend to be less volatile than a growth investment.

When growth investments make sense

When the time horizon for your planned major purchase is long enough, growth-oriented investments might be more appropriate than money market funds or other short-term investments. Growth investments, including many stocks and mutual funds, and sometimes real estate, are commonly used for long-term savings. Market ups and down have historically tended to smooth out over the long term, providing more growth than conservative investments.

Growth investments carry the potential for higher returns, but there is a higher risk that their value will drop during any given short period. Therefore, they are not the best choice for your emergency fund or for major purchases you plan for the short term.

How to borrow money for major purchases

If you need to borrow for a big purchase, you have some options at your disposal.

Home equity line of credit

A home equity line of credit (HELOC) is a line of credit that uses your home as collateral. It is a revolving line of credit with a variable interest rate, rather than a closed-end loan. HELOCs are often used for financing large purchases, in part because the interest paid may be tax-deductible.

Based on the value of your home, your lender will approve a certain credit line—the maximum borrowed amount that can be outstanding at any one time. Once you are approved for the HELOC, you can draw from it whenever you want, generally with checks.

Second mortgage

Unlike a HELOC, a second mortgage gives you a fixed sum of money to be paid back over a set time. (Again, interest may be tax-deductible.) Equal monthly payments are usually required to pay off the full loan. Borrowers who need only a set amount rather than a revolving line of credit may find a second mortgage more attractive than a HELOC.

Compare the costs of the HELOC and the second mortgage. With both, ask if there are costs in addition to those you recognize.

Using credit or installment loans

Many borrowers take advantage of credit cards or installment loans. These allow the borrower to repay the lender in repeating monthly payments, with either a fixed or floating interest rate. Each payment is a combination of principal and interest.

Interest rates on credit cards and installment loans tend to be high, however, especially on credit cards. Indeed, if one makes the minimum required payment each month, only a small portion will go toward principal. For this reason, this type of borrowing is the least desirable way to finance a major purchase.

Summary of financing a major purchase

As you can see, you will find some means of finance more suitable to your financial situation. If you need to borrow, you have options at your disposal. The critical thing is to start with a budget and find ways to afford your purchases with current cash.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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