We live in a world of monthly charges. Not only are conventional expenses like mortgages, auto loans and utilities billed monthly, many businesses have begun transitioning to a monthly subscription model. Businesses are annuitizing their income and this model has also proven to be psychologically palatable for consumers. Spreading service fees over a monthly basis tends to minimize the impact of the fee, causing some consumers to spend more than they may have otherwise spent. Interestingly, more consumers are focusing on the size of their monthly payments when determining affordability rather than taking into consideration factors such as interest rates and total overall cost when making financial decisions. This is especially true when it comes to financing big ticket purchases like homes and automobiles. Believe it or not, a larger monthly payment may actually be one of the best financial moves you can make.
Don’t be fooled by the mirage of lower payments.
It used to be customary for salespeople to ask, “Where do you want your payment to be?”. While it is usually not advisable to answer this question in a negotiation, many consumers have based purchase decisions around keeping their payments as low as possible. The problem here is that doing so usually requires that either the purchase price be lower (which usually isn’t the case) or the term of the loan is longer. Nowhere has this been more prevalent recently than in the automobile industry. According to Experian, the average loan for a new car is now approaching 70 months with an alarming number of buyers choosing even longer terms such as 84 months. While reducing the monthly payments through a longer term may seem like a smart money move, the reality is that a longer loan term usually results in higher interest rates and higher overall costs.
In fact, the difference in total interest paid between a 48-month loan and a 84-month loan can be substantial – nearly twice as much depending on interest rates and terms. With fewer dealers offering 0 percent long-term loans than in the past, it is critical to understand the financial impact of long-term financing. Consumers should consider questioning the purchase if the only way they can afford a vehicle is to finance it over 84 months. Extending payment terms can sometimes make the unaffordable seem affordable.
There are few places where the loan term matters more than when it comes to financing a home. Why are most mortgages financed for 30 years rather than 20 or 15 years? It’s simple, just like with auto loans, consumers may be unable to afford the monthly payment on shorter-term loans. However, with interest rates still at attractive levels, it is important to understand the benefits of choosing a shorter loan term and higher payment when selecting a mortgage. Remember, with all other variables held constant, a shorter-term mortgage at lower rates may result in substantial savings. For example, a $250,000 loan at 3.9 percent for 30 years will result in monthly payments of $1,182 and a total cost of $425,533. By spending $575 more per month, a homebuyer could select a 15-year mortgage and may save over $109,000 in interest costs. While having the funds to afford a shorter loan term may be easier said than done, the financial benefits can be substantial if you have the cash flow to support the additional payment.
Loan terms should also be carefully considered for homeowners choosing to refinance. For example, a homeowner with a mortgage at 4.75 percent with 20 years remaining may be able to refinance and cut their loan term to a 15-year mortgage for only a slightly higher payment, resulting in significant interest savings.
Know your numbers
Deciding to minimize interest costs when financing big ticket purchases requires clarity on your available cash flow. You have to be careful not to overcommit funds that may not be available in the future. It is also critical to ensure that shorter financing terms and larger payments do not impair your ability to continue to save and invest for other goals such as education funding, retirement or insurance needs. For example, it may not be advisable to select a 15-year mortgage over a 30-year mortgage if you will no longer be able to max out your retirement contributions.
While it may seem counter-intuitive, selecting loan terms that result in higher payments could end up minimizing excessive interest expenses. Deciding between loan terms also highlights an important question regarding the affordability of your purchases and what may be best for your long-term goals. Since everyone’s situation is unique, consider speaking to your financial adviser, tax adviser and attorney to determine the most appropriate approach for you.