Thursday, November 20, 2014

Car Loans Are Too Costly and Too Lengthy ... Home Mortgages Too ... Watch the Total Dollars, and Not Just the Monthly Payments

Lenders are in business to loan money at a profit. Sellers want to get as high a price as possible in each transaction, so they try to 'trade up' the purchaser to the 'best' and highest priced item in a good-better-best offering.

On the other side of the table, borrowers should be taking on as little debt as possible, and for as short a time period as possible, in order to get the lowest total payments and interest rate possible for the duration of the loan. They probably should buy the 'good or better' item and not the highest priced 'best' one with all the bells and whistles attached.

Unfortunately, that's not the way things tend to work out in the real world. As a result, sellers and lenders generally 'win' at the expense of the borrowers.

When borrowing, we tend to look solely at the monthly payments required and ignore the length of time it will take to repay the loan.That's what all lenders encourage borrowers to do, and it works to the benefit of the lender and seller, while disadvantaging the borrower.

The less we borrow and the shorter the time we owe the money borrowed, the less total dollars we pay to own free and clear the asset we're purchasing. It's that simple.

In fact, the 'easy affordable' monthly payment often takes center stage in lending negotiations and the total amount of dollars needed to repay the debt obligation is largely ignored by borrowers. As a result, low monthly payments lead to bigger purchases in dollar amounts, which in turn lead to longer term loans, all resulting in more money received by lenders and more money paid by borrowers. Taking more time to repay the principal of a loan may result in more affordable 'easy' monthly payment obligations, but it also leads to much more in total dollars paid by borrowers over the term of the loan. That's good for the lender and bad for the borrower.

{NOTE: We'll use the car loan example herein, but the exact same logic applies to home mortgages and other term loans. Individuals should make as big a down payment as they can handle, then borrow the remainder of the purchase price for as short a time period as possible and receive a lower interest rate on the money borrowed. That way less total interest is paid, and the entire debt is retired relatively quickly.}

More Expensive Cars Are Leading to Longer-Term Loans has the story:

"It used to be that a car loan lasted three or four years. After 36 or 48 months of payments, you could drive debt-free for a few more years, before deciding if you wanted to get a new vehicle.
But times have changed in the automobile buying world.
Six-year loans are now typical . . . . the average length of a new-car loan (is) 66 months, or five and a half years . . . . About 41 percent of loans were for five to six years and about a quarter were for six to seven years. . . .

Longer-term loans, particularly 72-month loans . . . have become the new norm. . . . available across all makes and models, and for borrowers with all sorts of credit scores. . . .
Ron Montoya, consumer advice editor for Edmunds, said buyers were spreading out the time over which they pay for their new cars to achieve lower monthly payments. “Cars are getting more expensive,” he said, and longer loan terms give consumers more room in their budgets....

The downside of longer loans, however, can be considerable. Longer loan terms . . . carry higher interest rates, which will increase the total cost of buying the car. If you’re paying off the car loan for seven or more years, you’re more likely to be tired of the vehicle and trade it in immediately for another one once it is paid off, starting the debt cycle again. “The average person gets tired of their car at around six years,” Mr. Montoya said. “The idea is to actually own it and have zero payments at some point.”
And the value of the car, once it’s finally paid off, will be less after six or seven years than after four or five years. That means you’ll have a car of lower value to sell or trade in toward a new car purchase.
Anthony Giorgianni, associate finance editor at Consumer Reports, said buyers should avoid long-term loans. “The auto industry and the dealers have everyone focused on the monthly payment,” he said. “People really need to look at the bottom line.”
For instance, if you borrow $30,000 at 3 percent over four years, your monthly payment will be about $664 and your total interest will be $1,873, according to an auto loan calculator on With a 72-month loan at the same rate, your monthly payment would be $456, but your total interest cost would be $2,818, or an increase of $945. (Also, rates on a longer-term loans are generally higher, so the actual cost will be even more.)
For that reason, Mr. Giorgianni suggests that buyers make a down payment, say, 15 percent. And if consumers need to stretch a loan to six or seven years to afford a particular car, he said, they should consider a less expensive model. Mr. Giorgianni drives a 1992 Explorer for which he paid cash, he said. “It’s a wonderful thing.”"
Summing Up

Purchasers should buy only what they can reasonably afford, and they should focus on the total payments required to retire the debt, including interest and principal, instead of the required monthly payments.

That means a reasonable down payment should be accompanied by a loan of relatively short duration. In the case of a car loan, the term should be not more than 36 to 48 months (15 to 20 years for a home mortgage, with the interest rate adjustable rate every five years to get the lowest interest rate possible).

The asset will then be owned free and clear, and unencumbered by burdensome debt, and the borrower/buyer will be relieved of the obligation to make future payments. Perhaps the then happy and debt free buyer will be able to purchase his next car by making a really big down payment and assuming very little if any debt.

That should be every car buyer's long term goal.

That's my take.

Thanks. Bob.

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