I recently read a message board post written by somebody about a car purchasing transaction.
They were talking about somebody borrowing money at a 7.4% interest rate and them having a total amount owed (assuming minimum payments) of 41k or so over 7 years. This was related to a trade in and the original car was still underwater. The stated selling price for the car was 24k.
There are a lot of things wrong with this, but we will go with that for example purposes.
If you reduce the 41k at 7.4% back 7 years, you end up with an amount of a tad over 26k. If it was an interest only loan, you would pay a bit less than 60% of the total loan value on the way up and then owe the whole 26k back at the end in one big payment.
Given that this is a loan that requires paying some principal every month, the realistic amount borrowed is probably closer to 30k.
The poster was having trouble reconciling the 24k negotiated price for the new car and the 41k amount owed.
This is one of those times where people don’t fully appreciate all the costs of borrowing. They were looking at the negotiated sticker price as the end and it’s actually the beginning. They start tacking on fees and stuff on top of that. Fees just to borrow the money to buy it, fees to ship the cars to the lots, fees for paint coating, and fees to put the dealer logo on it. Stuff like that.
The real cost to buy something has to include everything that comes along as part of buying that thing.
The last time I was buying a car, I kept throwing the financing guy off by refusing to talk in terms of monthly payments. Everybody talks in terms of monthly payments, right? He had serious trouble making it through the discussion without talking about monthly payments and kept defaulting to it because that’s all he was really trained to do.
When they say it adds 40 a month, what they really mean is that it adds another thousand in total cost. Do I really want to add another thousand for that? No.
Gap insurance for cars is the worst. Gap insurance helps you if you are underwater on amount owed. Just never buy it. Just raise your own minimum payments like you had bought it and don’t buy it. This will get out out from the situation of being underwater pretty quickly. That’s a lot better than paying to stay underwater is.
No, we don’t want to pay an extra thousand so we can stay underwater and bet on totaling the car within a month of purchase.
When you talk in terms of amounts owed, a lot of stuff becomes a lot clearer.
Going back to the example above, the poster shouldn’t be looking at these minimum payments and calculating that they will owe 41k over 7 years. They should really be looking at how they can avoid owing 41k.
If you are going to take a loan at 7.4%, all you should be thinking about is how to pay that thing off ASAP and reduce the money wasted on interest payments. It is not worth holding such a loan to maturity.
Maybe it’s worth holding a house loan at 3.5% fixed to maturity, but any loan that is at about 4.5%+ fixed should be paid off ASAP. That should be your financial goal. It should be a given that you are paying a lot more than the minimums. More like every spare dollar.
Paying off a loan at 7.4% is like guaranteeing yourself a 7.4% interest rate on amounts invested. That’s a huge rate to lock in as guaranteed. There isn’t any way to get a guarantee like that short of paying off debt you owe with high interest rates. Stocks, bonds, real estate, nothing gives you guarantees that high.
If somebody offered me a guaranteed 7.4% on amounts invested, I would seriously cut back my lifestyle and put every possible dollar into that investment.
You can easily get that by just paying off high interest debt. If I had a debt at 7.4%, I would be seriously cutting back my lifestyle and paying every possible dollar to pay off the debt ASAP.
You do not want to stretch out the damage over 7 years. Two years at most.
The dealership gave me my car on a 5 year loan at like 4.5%ish. I had the title in under 2 years. Student loans wanted to stretch me out 30 years at 6.3%. Those are all down to zero balance now too, about 6 years later.
Zero interest on amounts borrowed ATM. It’s great. Not paying high fixed payments on cars and student loans frees up a lot of free cash flow to put towards net worth.
I think if people thought more often about their net worth, they would be a lot more unwilling to buy stupid little things that decreases their net worth by thousands of dollars a year.
Smoking = 5000/y
Starbucks = 1000/y often maybe 2000/y
Gap Insurance = -1000/car
Stuff like that. Those aren’t including gains on the money otherwise invested. If you can get 5000 into a savings account at 5%, that’s 250/y to the plus rather than 5000/y to the minus.
I am convinced that the only reason people smoke is because they don’t grasp the real cost of smoking. They look at a pack at $4 and they don’t see forwards that they can live a lavish retirement on +5000/y throughout the investing years.
Don’t smoke, really.
Am I getting off track here? We were talking about amounts borrowed.
Sorta, but not really.
Everything is financed.
Anything you buy and by extension any amount you borrow involves sacrificing the money you would have had at a later time if you invested that amount instead.
If you are a young person, call it 25, and you want to feel like you are somebody important and you go buy a single cup of coffee at Starbucks. One of those ridiculous ones where it takes you 2 minutes just to get through the order on one cup of coffee. The one where you throw out stuff like “half caf”. You know the type.
That might cost like $12. You don’t even know, because you are swiping and not even listening to the price.
What would that $12 have been 40 years later at a conservative rate of return of like 4.5%? Try $70. At 5% is $84.50. At 5.5% is $102. That’s for each cup of coffee you skip. Every time you get a cup for 50 cents, you are pocketing most of that $12.
Amounts borrowed are just worse, because instead of making you money they are actively working against you. At least wasting your money on Starbucks isn’t working against you actively.