As we were sitting in the salesman’s office, I remember thinking we were totally rocking our negotiation skills. Our sole focus was to get the monthly payment as low as we possibly could. While I cannot remember the details of the transaction, I do know when we agreed to purchase the car, we had no idea what the total cost was.
Though this car was used, it still cost half a year’s income. I was in grad school and my husband was working a temporary position. We had no savings and were living on a low monthly income, so the only way for us to buy this particular car was to finance it. In hindsight, this was a foolish decision.
Live and learn. We’ve come a long way from those days, but we made the “monthly payment” mistake many times before we finally learned our lesson.
The monthly payment trap has ensnared most of us at one time or another.
Fixation on payment alone is deceiving. The interest rate and term of the loan should never be ignored.
Ask: What is the actual cost of the purchase at the end of the term, including all fees, taxes, and interest?
The monthly payment may fit into your budget each month, but it’s just a snapshot of the big picture.
Ask: How is this loan going to affect overall net worth? Am I adding to an already large pile of consumer debt? Is it going to hinder emergency savings or college/retirement investments?
Cars
While a $250 car payment may seem affordable (and it’ll slide into your budget, no problem!?), let’s look at the true cost of the car over time. (Tax, title and license vary from state to state, this info is based on estimated costs in the state of Illinois)
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If you take the full 84 months (that’s an entire 7 years, people!) to pay for the car, the amount paid for the car with interest is $2222.53 (interest) + $27220 (price and fees) = $29442.53.
A seven year loan brings the payment down, but that’s a dreadfully long time to pay for a car. By the time you have the car paid off, it will have depreciated to a value less than ⅔ the purchase price.
If you want to sell this car a couple of years down the road, you could conceivably find yourself “upside down” on your car loan, meaning you owe more on the car than it is actually worth. A car is not an “investment” – it loses value each and every day.
Look at the total cost and decide how it fits into the overall picture of your finances.
Furniture, Electronics and Appliances
Financing purchases such as furniture, electronics and appliances is typically a bad idea. If you don’t have the cash to pay for these items, don’t do it. Even if you get a 0% interest rate over time, you are still going into debt to make the purchase.
Rent-to-own stores often charge up to 300% more than an item is worth. An example from Consumer Reports illustrates this well:
Consider the deal for a $612 Toshiba laptop computer we found at one rent-to-own store. It was being offered at $38.99 a week for 48 weeks, for a total of $1,872, excluding sales tax and other charges. That’s the same as buying the laptop at the manufacturer’s suggested retail price and financing it at an interest rate of 311 percent. You could buy three of the laptops outright for that $1,872.”
Minimum Monthly Payments on Credit Cards
Making the minimum monthly payments on credit cards leads to consumer debt that can last an eternity.
Let’s say you make a purchase of $1000 on your credit card (assuming 20% interest). If you only pay the minimum payment of 2.5% each month, you will end up paying $2197.09 for the original purchase over about 10 1/2 years. Was that new sofa worth it? What condition will it be in when you pay it off in 10½ years?
Cable, Cell Phones, and Subscription Services
Cell phone, cable, and subscription services are monthly payments too. Rather than taking the monthly view on these expenses, take a step back and ask yourself if a $100/month cable bill is worth $1200/year (or $6000 over 5 years!).
Mortgage
Granted, most of us do not have close to enough cash lying around to buy a house outright. Mortgages do serve a purpose and aren’t considered “bad” debt, but they are still debt! Just because a house can gain in value over time and the interest rates are currently low, doesn’t mean you shouldn’t evaluate the total cost.
I was astounded at how much house the online calculators say we can “afford”. We certainly cannot afford what they say we can.
Unfortunately, many people purchase homes with a price tag matching the amount of the loan the bank qualifies them for. Yet, how much house the bank says you can afford and how much you should spend are two different things. (A general rule of thumb is to aim for about two and a half times your salary, less if you have credit card debt or other large financial obligations.)
The banks have no idea how money flows in and out of your life and do not consider non-debt expenses or goals for savings and retirement.
Beware the monthly payment!
Remember, those offering a loan are making their money on interest rates and finance charges and those selling a product make their money on service contracts, warranties, and add-ons.
Whether you are buying a new car, furniture and appliances, or signing up for a new service, don’t ask how much of a monthly payment you can afford, but what the true cost will be over time.
Put aside the amount of a car (or furniture, appliance, etc.) payment into a designated savings account for a year or two and pay cash instead of financing. Or sell some of your “stuff” to pay for the purchase.
Whatever you do, avoid the monthly payment trap when possible!
What monthly payment traps have lured you in?
I couldn’t agree more that making “purchases” through monthly payments is a step in the opposite direction from freedom! The only thing we’ve ever paid for by monthly payments is our home. Even there, we got the early payoff bug because it just feels like anti-freedom!
Kalie, you are way ahead of the crowd by only using monthly payments for your home. We are discussing an early payoff on the mortgage too. It’s a daunting task, but the end result is exciting to think about!
This is good advice, but I disagree somewhat about interest free financing. Recently we moved and purchased hardwood floors which we installed throughout the entire home except for the kitchens and baths. The total cost for materials was $4,800 for Bellawood floors which are guaranteed for 100 years. The store had a promotion offering 24 months financing interest free. While the minimum payment is $148, we are paying $400 per month to have them paid for in 12 months.
We could have paid cash, but I decided to leave that money in savings earning interest and take advantage of the free financing. So, I really feel that interest free debt is not always a bad decision.
Thanks for the thoughtful comment, Rebecca! I don’t disagree with you – you have been responsible about your purchase! You are working to pay it off early, plus you understand that if you don’t pay it off in the 24 months, interest will begin accruing.
I can see how it can work for some but, unfortunately, some people are drawn in by the 0%. These folks have good intentions of paying it off, but may not make it a priority in their monthly spending and, in the end, pay interest after the initial 0% interest term expires.