From THE HINDU group of publications
Sunday, July 01, 2001


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The credit or cash question

B. Venkatesh

CONSUMERS have never had it better. Competition has driven down the prices of TV sets, washing machines and the like. Better still, lower interest rates allow for cheap borrowing. Small wonder, then, that the credit purchase of consumer durables has increased considerably in recent times.

But should you buy consumer durables on credit just because interest rates are down? No. You should base your decision on the opportunity cost principle.

Suppose you have Rs 25,000 on hand and propose to buy a washing machine. Further, suppose your neighbourhood salesman is willing to sell you a washing machine on instalment at an interest rate of, say, 13.5 per cent for 18 months. What should you do?

If you opt for the instalment scheme, you will incur an interest cost of 13.5 per cent, but you will have Rs 25,000 cash, which you can invest.

The decision rule is this: Can you expect to earn at least 13.5 per cent for 18 months by investing Rs 25,000, the amount that you would have otherwise used to buy the washing machine?

If you cannot, it is better to pay cash and buy the washing machine. You just have to apply the opportunity cost principle to arrive at our decision.

Of course, this principle may not apply when you do not have the money but still want to buy the washing machine!

You can nevertheless make a smart purchase. How? Suppose your bank is willing to lend money for purchase of consumer durables at, say, 12.5 per cent. You save if you borrow from the bank and buy the washing machine rather than opt for the instalment scheme.

In most cases, interest rates on instalment schemes are higher and have clauses written in small print. For instance, you will have to bear a flat interest rate rather than on a diminishing balance. You, thus, need to be very careful when buying goods on instalment.

That apart, the central message is this: Buy goods on credit only when you do not have disposable cash or when your opportunity cost is lower.

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