Best Way to Finance Large Purchases – UNBROKE Financial Literacy Tip

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At one time or another most people will likely have to finance large purchases. Whether we’re paying for a car or a house, how we decide to pay for life’s major purchases will have a huge impact on our personal finances years after that major purchase is made.

When you go to buy a car, what is the first question the salesman usually asks? Not, “How much would you like to purchase this car for?” More likely you will be asked, “How much would you like to spend each month?”

This is how most people decide on their major purchases. They aren’t looking at total cost. Instead they focus on whether the payment fits into their monthly budget. While it may make sense at first glance, this approach to financing major purchases is all wrong. To prove the point, let’s look at some examples:

How to Pay for a $40,000 Car

So you have decided you want to purchase a new car. You’ve decided on one that’s priced at $40,000. When it comes time to sitting down with the nice car salesman, you are given two options.

The first option is to finance the car over four years at 4% interest. The other is to finance the vehicle over seven years at 6%. Of course this means nothing to you until you hear the monthly payments, which are $903.16 and $584.34 respectively. Now we have something to talk about.

After hearing the first monthly payment you feel utter despair. You simply can’t afford to make payments of over $900, but after hearing the second number you are thrilled and sign the paperwork immediately. Unfortunately, you have just made a very bad and costly decision that will affect your personal finances in the years ahead. Instead of looking at the monthly payment, we should look at the “total cost,” meaning principal plus interest paid in both scenarios.

We just agreed on seven-year financing, which will end up costing us $40,000 (the purchase price of the vehicle) plus $9,084.74 (the interest to be paid on the loan) for a “total cost” of $49,084.74. On the other hand, if we agreed to the four-year financing we would have paid the same $40,000 for the vehicle, but the interest would have only been $3,351.78.

Financial Impact Down the Road

That $5,732.96 difference may not seem all that material, but after saving those funds if you choose to invest it and let it grow the next 20 years at 6% interest, you would have an account worth over $18,000. Over 40 years it would be almost $60,000.

How many people around the age of 25 have made one or two bad decisions already with their auto financing that will eventually deprive them of an extra $20,000, $60,000 or even $100,000 at retirement?

The other issue here is that you are borrowing for an asset that is depreciating in value. The minute you drive that car off the lot, you have just lost value. Every mile you put on that car makes it less valuable. Every ding equals less value. To see how much car loans cost over time click HERE.

Now what happens after a couple years when you want a new car with fewer miles and dings. You find out that you actually owe more for your car than what the dealership is willing to pay you for it. So the friendly salesperson gives you two options. The first is to bring cash with you so you can pay off the difference. The other is to roll the difference between what you owe plus the value of the car into the financing for your new car. This rolling debt thing sounds expensive, but not to worry, they can just extend the financing on the new car to make it “affordable,” at least that’s what they will tell you when they offer to extend an eight-year loan…

Buying a $300,000 Home

Now that you have some understanding of timeframes and interest rates, you likely can imagine what kind of impact financing a home over 30 years versus 15 years can have. However, we are going to look at the numbers anyway to drive home the point.

Financed over 30 years at 4.5%, the $300,000 house will cost us $247,220.13 in interest alone, meaning the “total cost” will be $547,220.13. Instead if we choose a 15-year loan at 4%, we would pay less than $100,000 in interest; $99,431.48 to be exact, for a “total cost” of $399,431.48.

A Lot Can Change in 30 Years

There are two major arguments that can be made here in favor of the 30-year mortgage. One is that the interest you pay on your house is tax deductible. The other is that your house, over time, should appreciate in value.

I don’t disagree with either point, but I would say that from recent events, including the 2008 housing bust and changes in tax law, we should have learned that there are few things we can really bank on. The one thing you can always bank on though is that it is better to not have any debt than to have a lot of debt. Short of that perfect outcome we can always say, the less debt you have, the better.

Unless you are born very wealthy you will have to borrow money to make major purchases. Borrowing in itself isn’t a problem when done thoughtfully, and with an eye toward the future. However, if done poorly, it can have a negative impact every part of your personal finances in the future, even in retirement.

If you aren’t currently working with a CERTIFIED FINANCIAL PLANNER™ Practitioner you can learn more about my practice HERE or you can find other CFP® Practitioners HERE.

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UNBROKE is a financial literacy blog for the financially illiterate. When financing anything be sure to look at the total cost not your monthly payment.

 

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Charles Weeks
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Charles Weeks

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