Home renovation payment: Loan with interest, lump sum with discount or quarterly payment with no interest

Question

I have a home renovation that would cost me 50k. The company offer me these options:

1. 50k 15 years loan with 3% per annum fixed interest (monthly repayment)
2. 45k lump sum with 5k discount
3. 5k quarterly payment (total is 10 quarter)

Right now I have 50k in unit trust and for the past 12 years, the dividend has not went down below 5% per annum. Taking consideration with my cash in unit trust, which option is the most beneficial to me?

Answer 1

There are two aspects here. One is the total amount of interest you pay, and how that compares to what you could earn, but the other is more psychological. The payments on the 15 year loan would be just under 300 a month. The payments on the third option would be 5k a quarter or 1250 a month. Can you afford either of those amounts? If you can, then leaving your investment alone and making this payment leaves you with more money at the end than liquidating your investment and hoping you save that much again over the next few years.

The 5k discount for paying all in cash could instead be presented as

• the product costs 45k
• if you want to pay it back over 2.5 years, add another 5k to the total for that privilege (this is less than 5% per year)
• if you want to pay it back over 15 years, add the 5k plus pay 3% a year (this is still probably less than 5% per year, but it's close)

It seems like the "savings" by paying immediately don't beat what your investment is earning. And by leaving your investment alone and finding the money to pay for this as you go, you are assured your investment remains intact.

Of course, if you can't afford those payments and would have to keep dipping into the investment to make a payment, the calculations are different. There may also be tax implications, but those are location-specific.

Answer 2

If I was in this situation, I'd take option 3 if I could earn 5k per quarter. This was I could leave the "unit trust" in place, and have the loan paid off in a reasonable amount of time.

Answer 3

There are two principals that need to be followed in comparing two scenarios:

1. You cannot compare or combine cash amounts that exist at different moments in time. Adding the interest portions of various payments over the life of a loan, for example, is not useful.
2. You need to compare scenarios that are as similar as possible, to isolate the effect of the particular difference between the scenarios.

In this case , let's consider three individuals; all have a $50,000 nest-egg earning 5% a year interest, and a burning desire to have a home renovation that can be paid off in various ways.

Andrew decides to take the first option: paying the $50,000 "price" by regular monthly payments over 15 years at 3% a year interest.

A loan calculator (Regular Payment version) tells Andrew that this means 180 monthly payments of $345.29

Being a forgetful person, Andrew decides to set aside approximately $43,650 of his nest-egg to fund the payments. A different type of loan calculator (Principal version) tells him that this portion of his nest-egg will, while earning 5%, be reduced to $0 if the 180 regular payments of $345.29 are taken from it on a monthly basis.

That leaves Andrew with his reno paid in full, the monthly payments provided for, and approximately $6350 in his nest-egg uncommitted.

Belinda chooses the second option, the "discounted price" route.

She cashes in $45,000 of her nest egg, pays off the contractor in full, and finds herself with with no further payments, and $5000 uncommitted in her nest-egg.

Charles decides to make 10 quarterly payments of $5,000 over two and a half years. Again, a loan calculator (Principal version) reveals that $46,720 of the nest-egg earning 5% will be reduced to $0 while funding the 10 quarterly payments. So Charles finds himself with the reno paid off, with no more payments to make, and $2380 uncommitted in the nest-egg.

So, Andrew comes off best, Belinda spends about $1350 more than Andrew and Charles brings up the rear spending almost $4,000 more than Andrew.

All these amounts are as of the date of payment of the bill.