Tuesday, May 22, 2007

The True Price of Affordable Loans

We all know it's a bad idea to let an eight-year old loose in a candy store. Temptation and self-restraint will be mismatched, and cavities, hyperactivity and weight gain will follow. Today's credit market is about the same.

The U.S. economy is awash in credit. Vast quantities of the stuff roam around in every direction, like the enormous herds of bison that swept across the prairies 150 years ago. The abundance of credit puffed up the real estate markets until they bubbled and popped. In the financial markets, the ready availability of credit has enabled hedge funds to accumulate vast investment portfolios funded by borrowed money, and more recently has financed a flurry of "private equity" deals, in which private investors and corporate managements buy up major public companies using credit that banks line up to provide. All this activity has pushed blue chip stocks to record levels. But are these prices sustainable? Only time will tell.

For consumers, there's no shortage of credit, either. Credit card offers in our daily mail kill entire forests. If you have any unused equity in your home, banks rush to offer home equity lines of credit to burn up that equity and convert it into debt payments for you. Car loans now have longer and longer terms in order to make them "affordable" (meaning small enough for you to pay each month). All of this comes at a price, and it isn't cheap.

Car loans illustrate the point. Back in the bad old days when grown men wore leisure suits, cars were usually sold with three-year loans. If you assume an interest rate of 6%, a three-year loan increases the dollar cost of the car by about 10%. For example, a $25,000 car ends up costing about $27,500.

Today, many car loans have terms of five to six years. A six year loan at 6.5% (rates on longer term loans are higher than rates on shorter term loans) will increase the total dollar cost of the car by about 20%. The same $25,000 car ends up costing in the range of $30,000. Of course, the monthly payment on the 6-year loan is much lower--maybe 40% lower (about $425 a month for the 6-year loan, versus approximately $750 a month for the 3-year loan). That's why people take out the longer loans. But they end up paying more for the same car.

A related problem comes up with real estate mortgages. Some mortgage lenders are now offering 40-year fixed rate mortgages as a way to qualify people to buy homes. Arithmetically speaking, a 40-year mortgage costs many more dollars than a 30-year mortgage (around 30% more; so if you're talking about a $200,000 mortgage, that's an extra $60,000 for the same house).

You don't plan to stay in the house for 40 years, so you ask why does it matter? Because the rate at which you build equity in the house is slower with a 40-year mortgage than with a shorter mortgage. The early payments in any mortgage are mostly used to pay interest charges. Only a small portion goes to reducing the principal balance of the loan. As you make more mortgage payments, the amount that goes to reducing the principal gradually increases and you begin to build equity in the house (equity being the value that is yours). A 40-year mortgage with an interest rate of 6% increases your equity in the house by about 8% of the amount of the mortgage loan after the first ten years (about $16,000 for a $200,000 mortgage). A 30-year mortgage with the same interest rate will increase your equity in the house by about 16% of the mortgage loan in the same time period (about $32,000 for a $200,000 mortgage). Given that housing prices are now flat or dropping in most areas, paying down the principal of the mortgage is pretty much your only way to build equity. The monthly payments on a 40-year mortgage might be about 8% or 9% lower than the monthly payments on the 30-year mortgage. But you pay a large price in terms of slower equity growth to get that reduction.

For more information about the risks of financing your home purchase with "affordable" mortgages, please read our May 10, 2007 blog, "How the Right Mortgage Loan Helps You Build Wealth" (http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html).

Remember that you will get a finite amount of money in your lifetime--basically, what you earn, what you gain from investments, anything you inherit, and your lottery winnings (haha, just a joke for 99.9999% of us). The more of your finite lifetime income you spend on interest payments, the less you will have for steaks and champagne. This is a zero-sum game: either the banks get your money, or you get it.

The reason why banks crowd around throwing credit at you is because they stand to make big money lending to you. From your standpoint, the problem with that is the big money comes out of your pocket. Borrow if you must, and borrow for a good reason. Getting an education is a good reason. Buying a house is a good reason. Buying a car is a good reason. But not every loan is a good loan. Buy less house or less car if necessary to keep your borrowing under control. You can't borrow your way to a comfortable retirement. You can save your way to a comfortable retirement.

Celebrity News: Paula Abdul and the risks of owning a Chihuahua--http://www.nbc4.com/entertainment/13364020/detail.html.

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