There is a saying that goes something like this:
If you need a loan for something, you can’t afford it.
Loans of all types are exceedingly costly. That includes home loans, car loans, student loans, credit cards, and pretty much any other sort of loan.
The concept of a loan is simple enough. You borrow some amount of money and then you agree to pay it back over some length of time at some amount per month.
The part that’s hard for most people to understand is the total cost of borrowing. It should be simple enough, just take how many payments they want you to make an how long they want you to make those payments.
A new car might be $550 per month for 60 months. Multiply that out and it’s $33,000. That loan is probably going to be on a car that has a $25,000 all inclusive cost. That extra $8000 is what you are paying just for the right to pay slowly.
If you instead paid $1000/m on that same $25,000 loan, you would be putting about $900/m toward the balance instead of about 400/m. You would pay it off in about 29 months for a total cost of about $29,000 with a cost of borrowing of about $4000.
Borrowing for 60 months is a whole lot longer of a time to be borrowing than 29 months is. That 550/m is going to be tied up that entire duration.
What you really want is to not have loans, in general. Their fixed schedules and their need to be repaid in general are very restrictive on your money coming in and your money going out. Having a lot of loans and loans with high balances makes everything in your life more risky.
Imagine you have a bunch of student loans, a whole lot, maybe $100,000. Then you get out of college and you are super lucky and you manage to get 2 job offers shortly after you get out of college. One of those job offers is 4000/m and in ten years that will probably be 5000/m. The other is 2000/m and in ten years that will be 10000/m.
Which would you rather take?
Which do you think the company that has your student loans will make you take?
Loans of having a way of doing that to you. They force you to make bad short term decisions. Even worse, the presence of a loan makes it more likely you will need to take another loan.
What they like to do is try to get you to stretch out the length of the loan really far, as far as you are legally able to.
This is particularly bad with home loans.
Just some general numbers – Pretend you take out a 300,000 loan and the mortgage is about 2200/m for 30 years. Multiply that out and it’s 660,000. The cost of letting you pay that slow is 360,000.
How much do you think you would have to add to that 2200/m to make it a 15 year loan? To cut the duration of that loan in half you would probably have to push payments up to about 2700/m. Multiply that out and it’s 486,000 with a cost of borrowing of 186,000.
Paying 20% more that your contractual minimum will usually drop your length of borrowing and your cost of borrowing drastically. Having to pay an extra 186,000 over 15 extra years is a whole lot of difference just to save yourself 500 bucks a month.
Don’t get me wrong, 500 bucks a month after tax is a lot of money. It sucks to have that much less to spend on other things. It sucks even more if you don’t have that much swing in your budget, because your pay minus your expenses leaves less than 500 at the end of the month.
The world is full of people that have less than 500 bucks a month left over. For that matter, a very large percentage of the world doesn’t have $500 period. I am not talking about 3rd world countries either. Of course the people making $1/day don’t have $500 laying around. I am talking about first world people like the average American citizen.
I read a statistic recently that something like 40% of adults in America don’t have $500 laying around.
I don’t really want to discuss that too much other than to say that a lot of the reason for that is because so many adults in America have a really strenuous loan burden.
For young adults, student loans combined with rent and a used car loan will put you to the point where you have maybe $50 a month left.
If you get married and your spouse works, you might be doing alright except that you probably have another car loan now and there is going to be some pressure to buy a house soon and have kids soon. Each one of those kids is going to cost you $100,000 or so in the time it takes them to become independent.
Do you need to save money to help them go to college now? What about your own retirement? How long until you need to buy new cars again?
The way most Americans live seems like it is designed to ensure that nobody ever has any money left over at the end of the month. A very high percentage of Americans are a short term job loss, a disability, or an illness away from financial ruin. They stay that way for most of their lives.
Such is the crushing burden of debt.
The worst thing about it is that the world wants it to be this way.
When you go to buy a car or a house, nobody ever talks about the total cost of borrowing. What they do talk about is the monthly payments. They do as much as they can to get you focused on the monthly payment number to distract you from the fact you will be in debt with more or less no freedom more or less forever.
If freedom is defined as the ability to go where you want, when you want, and do whatever you want, it is the banks that will do more than anyone else to prevent you from ever being free.
It’s not all their fault, though. The banks are the symptom in all of this. It’s not their mortgage that prevents you from ever being free, it’s your not paying cash for your house that prevents you from being free. You are the one signing up to pay 360,000 extra on a 300,000 house. The banks just make it happen.
We do that, though. We want that 300,000 house even if we are willing to give up all of those freedoms to get it. We want the car too. We also want the student loans that hopefully give us enough extra money to pay them back, hopefully with a little bit more besides.
Yes, we sign up for this, because that’s what we are supposed to do. Part of being an adult is joining the rat race. The one where they all line up on their wheels and start running and never get anywhere.
Enough with the doom and gloom, though.
Most people live that way, but we don’t all have to.
Some people in the financial world at some point figured out that we could actually be a whole lot more free if we paid off our debts more quickly. They ask us to give up some things now in order to pay our debts more quickly so we can have a lot more freedom.
Dave Ramsey believes in the debt snowball. Essentially, you put extra money on your smallest debt until it is paid off, then you take the money you were paying on the smallest and pay it on the second smallest and so on. Your free income per month slowly increases as you pay off the smaller debts until you eventually have none.
Then there is the debt avalanche. Essentially, you put all your extra money towards your highest interest debt and get that paid off the most quickly and then move on to the debt with the second highest interest rate. This way gets all the debts paid off more quickly, but to a lot of people it feels less rewarding.
Personally, I prefer the latter of those two. It leads to the lowest cost of borrowing. I feel most rewarded when I don’t waste money for nothing.
Don’t get me wrong, I am not paying cash for cars or houses either. I finance like the rest of us. I am not that rich. Not even close. The point is, though, that me and my family definitely do sacrifice now to pay our debts more quickly, and we are much more free than the average person for it.
We still have a rather sizable debt, but it’s at 0% and 0 fees for a $0 cost of borrowing. We aren’t taking advantage of a $0 cost of borrowing to get more in debt either, even though we could.
We want to eventually be free, though, at least as free as we can be while still having bills to pay.
That’s ultimately what loans are all about, freedom or the lack of it. When somebody takes a loan, they lose that much freedom. Freedom in relation to the total cost of borrowing, not the monthly payment. It’s the total cost of borrowing that kills you.
What is to be done for the average person, though?
If 40% of people don’t even have $500 laying around, they aren’t paying cash for cars, much less houses.
It’s tough to climb your way out after you already dug yourself a pretty deep hole, like most of us have.
Firstly, I like the debt avalanche method of paying off debts, for starters. The one where you pay the highest interest debt first.
Secondly, always pay your bills on time. Your credit score is a big deal. It makes your cost of borrowing go way down. Only hurt your credit score if you know you won’t need it for long enough for it to go back up to where it was. Keep a close eye on your credit score and take care of it like it’s a baby.
Thirdly, find ways to reduce your cost of borrowing. Having your weighted average interest rate under control is a really good idea. Interest is completely wasted money. Try to completely waste as little money as possible.
Fourthly, try to reduce your monthly expenses. Paying off debts helps that for sure. It’s not just that, though. Many debts have high monthly payments and low balances. If you can reduce your minimum payments, you have much more money to allocate to whatever you want to. The money freed up is flexible to be used however you want to. In other words, you are free to decide what to do with it. It gives you a little bit of your freedom back. Freedom you can use to buy yourself more freedom.
Fifthly, stop looking at minimum payments. If you are talking to a banker, don’t play their game. If you are buying a car, tell them you don’t even want to discuss monthly payments. You want to focus on the total cost of borrowing, and the monthly payments have nothing to do with that. The minimum payment you should be making yourself pay shouldn’t have any relation to the minimum payment they are making you pay. If you are going with their number, your cost of borrowing will be huge.
Lastly, find a way to make more money. This makes everything better. This doesn’t really have much to do with everything else other than it makes everything way better. The easiest way to get free of loans is to just make more money and use that extra to pay them off. It’s way easier than trying to save money. Learn some job skills you need to get a pay raise or a new job. Out of everything in the whole article, this is the easiest one to do and this has by far the biggest impact.