Thursday, April 12, 2012

Saving vs. Borrowing

I had a friend who works in our admission office ask me this question recently.

I was hoping you could help me with a little junior high math – it’s been a while.  I am working on a piece on ‘saving for college’ and researching all the myths and advice.  The following is from one of our more reputable sites on financial aid regarding how it is always cheaper to save than to borrow: 
I understand the concept, I believe, but I don’t understand why it works – sort of like those math puzzle games that just seem to be magic for reasons that baffle me.  I’d like to understand the dynamic so that I can present and counsel on the point more clearly when faced with one of our more popular questions, posed often combatively, “So, why the #$@% did I even bother saving all that money?!?”

Any teaching points you can offer, I’d appreciate.  
Someone wants a math lesson?   COOL!

Saving money (by putting it in a bank) is really a different sort of a beast than saving money by buying stuff that claims to be cheaper than other stuff.  The first kind really does help you get ready for other big events in life.  The second kind, well, that usually just translates into spending money.  It only really helps you "save" if you end up putting more money away for use in the future.

But that doesn't answer my friend's question.  Why is saving better than borrowing?  Here's what I wrote to him.  (Those of us who don't drink can replace "beer" with "ice cream sodas" and the explanation still works).
Ah, good question. The reason this seems so much like magic is that it's (sort of) the same total amount of money involved in either direction. 
The real difference is who pays the interest. If you save money, the bank pays the interest. Say, you put in $200,000; the bank puts in $100,000. You've got $300,000 to spend on education or beer. 
If you borrow $200,000, you pay the interest yourself. So you pay $200,000 PLUS $100,000. You pay more money: some for education, and some for interest, and there's nothing left over for beer.

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