What does that mean? When you borrow money there is always a cost – even if funds are borrowed from family, where the cost may be emotional capital. The primary cost is the interest charged on the loan. It can also be the cost of your time in earning the money, e.g. how many hours did you have to work to pay for the item. Let’s look at interest rate costs and how you may use borrowing money to your best advantage.
While you may think this is “too financial,” as in “I am not good with money,” it is a very important concept to understand. You may already understand the concept but think “it doesn’t apply to me.” When thinking about money and looking at budgets and finances, the “cost” of money now becomes very important. Especially, when you are looking at big purchases or have started accumulating credit card debt.
The “cost” of money is the interest rate and the total amount you will have paid at the end of a loan. How do you know what that cost is? How much more per month do you need to pay off the 30 year mortgage early? Why does it feel like you can’t make progress paying off your credit cards?! How many years will you have to work to pay off these student loans? Using an amortization chart or table can help you calculate the total costs for your loans. There are many calculators out there (yay!) to walk you through the process.
The answers to these questions depends on your credit rating and your needs. If you are trying to decide if you should buy a new car or a used car or if you have a older car should you trade it in to lower the payments. Usually the interest rate on a new car is lower than the rate on a used car. And, a new car usually comes with a good warranty so the maintenance should be less costly.
The real advantage if you owe money on your credit cards and you have an older car to replace, then borrowing the funds for the new car and selling your old car outright could be a better financial decision. If you can pay off your credit card with proceeds from selling the older car, it may be a better financial decision. A new car loan may be at 4% and the credit cards could be at 16%. It may make sense to pay off the credit card and purchase the new car. Or, use the older car proceeds to start an emergency savings account to ensure you don’t have to borrow more money on your credit cards. Or use the funds to help pay for college for your son or daughter.
The main goal is to have your money work for you. Perhaps, you want that new designer purse and the sale price is only $300! So, you think $300 is not too much so you charge it. However, if you are only making minimum payments (like $50), now that $300 gets added to a continually growing balance. In the long run, that purse will cost a lot more than $300 and that is not a bargain.
What if you have more than one credit card with a balance — eek! The Debt Snowball Method is needed! I have used this method when I was younger and it does work. Looking at your options can save you money in the long run. It can be tricky getting out of debt and trying to save for an emergency fund. The emergency fund is going to be critical to eliminate debt. So start saving even $10 per pay period into a savings account — usually credit unions are more favorable for not charging fees on small balances. Once you get a raise, you can up the amount even if it’s only $5. Use direct deposit to automate the savings, even if you think you can’t afford it. You can’t afford not too. You can withdraw the funds if you need to but surprisingly you will get used to it and not miss that $10.
If you are working and have the option to have a 401(k) or similar plan, please take advantage of it. I know it may sound like, how can I save for retirement when I owe on my credit cards? Two reasons! 1) your company match is “free” money and it is actually part of your salary compensation package. 2) Tax benefit! You don’t pay taxes on the contributions to the fund. If you can, contribute the minimum to get the match. If you can’t at first, do the minimum to participate and increase your contributions at the next raise (or once you pay off your credit cards).
Once you have your credit cards paid off, have an emergency fund, and are contributing to your retirement fund at work, you may want to buy a home. Most realtors and mortgage companies will try to sell you a house saying you can afford the payments for the 30-year loan.
However, looking at the amortization tables, BankRate.com, has a nice one, you may find that a 20-year loan at the same interest rate is not that much more and will save you 10 years of payments!! Most lenders are not suggesting the 15-year mortgages and try to steer you to a 30-year loan. And, if you ask about the 15-year loan they will often say, “you can still make double payments and still pay off your loan in half the time.” The issue is that most people won’t make the extra payments. And, some banks will only credit you the real savings if you pay the double payments on the exact due date.
You may ask why does this matter so much? For example, a house with a mortgage of $330,000 for 30 years at an interest rate of 5.27% may not look that bad at a base payment of $1,826 (before taxes and insurance) but over 30 years, that loan/house will cost $657,490. That is literally, almost the same as if you bought “two” houses!! Or the cost of the house and putting a child through a private college. A loan of 15 years will cost $2,656 (before taxes and insurance) is only about $800 more per month and the total cost is $478,128. Yes, this loan will cost about $150,000 more but it’s less than half of the extra $330,000 with a 30-loan. So, when calculating if you can afford a new home, consider a 15- or 20- year loan over a 30-year loan. Of course, there are other factors to consider when buying a home than just the cost of the loan. Making educated money decisions can make for a more comfortable life.
References: https://www.bankrate.com/mortgages/amortization-calculator/
