Borrowing

You Ask, Grow Explains: What Is Financing?

Sam Becker

“0% financing.” “6 months special financing.” You’ve likely seen such offers while shopping for cars, mattresses, and even TVs.

But what, exactly, does financing mean? Not knowing could cost you.

Issues related to financing rank among consumers’ top finance questions over the past year, according to data from Google. “What is financing?” is the 10th-most-asked question, just after “What is financing a car?”

So, what is financing?

“Financing” is another term for borrowing money, or taking out a loan. When you finance a car, for example, it means that you’re not paying for it up front—instead, you’re borrowing the money and making monthly payments to repay that debt.

“Financing is the method of paying for a good or service with future cash outflows,” says Mehmet Sengulen, a certified public accountant and managing director at New York-based UHY Advisors. “It’s living on tomorrow’s money.”

Typically, people finance large purchases, such as a house (through a mortgage), a car (auto loan), or even their college education (student loan).

The benefit of financing options is that they allow consumers to make purchases they otherwise would be priced out of. There aren’t many people who have tens or hundreds of thousands of dollars sitting around with which to buy a house or car, for instance.

"[Financing] is one of the main drivers of growth, because a lot of people are able to use financing to update or upgrade their lives,” says Amin Dabit, director of advisory services at financial management company Personal Capital.

How much does financing cost?

“The interest you pay is the cost of financing,” says Sengulen.

Generally, when you take out a loan you agree to an interest rate, or APR. These rates are attached to just about every type of loan out there, be it a mortgage, auto loan, or your credit card. Interest is charged on your outstanding balance, or remaining debt, as a percentage of that balance.

That’s the price of “using someone else’s money,” says Dabit.

Once you factor in that interest, consumers who finance a purchase can and often do end up spending more than they would have had they bought it outright.

And don’t be fooled by promises of “no interest” on a big-ticket purchase. Whoever or whatever is lending you that money is coming out ahead somehow.

“There’s no such thing as interest-free financing,” says Sengulen. “They’re baking the cost of that interest into the cost of the mattress.”

More from Grow:

Given the costs of financing, it’s smart to try and minimize the interest you’ll owe as much as you can by paying off your debt as fast as possible.

But what about those offers dangling low or no interest for a set period? To take full advantage, you’ll need to be able to pay off your entire balance by that deadline.

“You want to stop the clock,” says Sengulen. “As soon as you sign that agreement….that clock starts running. Every tick is the cash register ringing for the bank.”

Check out 5 Money Moves to Make Before You Buy a Home

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