Have you ever sat back and counted how many items you purchase in any given day, week or month? You're continually faced with purchasing decisions, ranging from that cup of java in the morning to that once-in-a-lifetime investment.

In this column, we'll provide you with some guidelines to follow whenever you're considering how to pay for purchases and investments.

RULES OF THUMB

Four rules of thumb:

�       Purchase consumable items with cash. Always use cash for any consumer expenditure. You can use a check, bank debit card or -- if you're disciplined -- one credit card. If you use a credit card, you must pay off your bill every month and incur no finance charges.
Otherwise, when you charge dinner on your card, you'll pay for the steak this month, the potatoes next month, and you may never pay off dessert.

�       Violate rule #1 only when you can earn more than the carrying cost of your borrowing. In some situations, you can earn more on invested funds than the carrying cost of borrowed funds. For example, let's say you're going to purchase a vehicle with a factory-to-dealer incentive of 2.9% for 3 years.
If you can't negotiate a lower price for the vehicle to compensate for paying cash, it may be best for you to take the attractive financing option, invest the cash and earn more on that invested cash than the carrying cost (interest) of the debt.

�       Borrow only for investments. As a general rule, we've counseled clients to leverage (borrow) only for investments.

�       We have developed a simple algebraic rule to determine when to borrow. Simply stated, you should borrow for investments only when your after-tax total return exceeds your aftertax cost to carry.
For example, Dr. Goodvision purchases securities for $10,000 at the beginning of the year, receives $500 in dividends and has $2,000 in capital appreciation, so the brokerage account balance is $12,500 at the end of the year.
The $10,000 was borrowed at a 9.5% interest rate ($950). This interest can be deducted on the current year's income tax return. If Dr. Goodvision's marginal tax rate is 40%, the tax savings from this deduction is $380.
The total return is $2,500 ($500 income and $2,000 capital appreciation); the tax cost is $200 ($500 x 40%).
We didn't include the 20% capital gain tax on the $2,000 because Dr. Goodvision did not want to dispose of the security. The cost to carry is $950 and the tax benefit is $380.
Therefore, the after-tax total return is $2,300 ($2,500 minus $200), and the after-tax cost to carry is $570 ($950 minus $380). The after-tax total return exceeds the after-tax cost to carry by $1,730 ($2,300 minus $570), or 17.3% real annual return.

�       Minimize negative cash flow investments. Even when the investment passes rule #3, we caution clients to minimize investments that generate negative cash flow.
Although the strategy outlined above does produce a positive total return and a respectable annual rate of return (17.3%), it still generates a negative cash flow by $270 ($1,730 after-tax net total return minus $2,000 capital appreciation).
This means it may be a "good" investment, but you can only have a finite number of "good" investments before you run out of money.

CONCLUSION

When making a purchasing decision, remember the four rules of thumb from this article. If you apply them consistently, you will simultaneously maximize the value of your consumption and your investments.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., and Anita S. Frank, CPA, are president and tax manager, respectively, of The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group provides personalized fee-only financial planning, investment management and business consulting services.