We all know by now the basic interest cost of a loan. If we have a $20,000 car loan at 7% interest for 5 years, the amount of money we pay back is approximately $23,800. Thus, the cost of the loan is $3,800 (interest paid) plus any origination costs (e.g., car dealers may add on another $50 or more for their services). For me, the cost of a loan like this is not that big of deal because it is fixed cost, relatively low interest rate and a large part of the interest rate is due to inflation.
When inflation is reflected, the cost of the loan decreases significantly. Assuming 3.5% inflation rate, the cost of the loan is broken down to $1,900 for inflation (purchasing power because $1,000 today is worth $1,035 next year) and $1,900 ($3,800 – $1,900), is for the lender’s profit to do the loan. The real cost of a loan net inflation reflects the profit for lender to reflect risk and lender’s opportunity to use money elsewhere.
For me, paying a little bit more in the future due to inflation versus paying it off now is a wash especially if wages are indexed for inflation because of the equivalent purchasing power (this ignores the possibility of earning more on investing versus paying off the debt). For example, for someone earning $50,000 and purchases a $10,000 car, he could pay off the car in year 1 (at 20% of his salary). Otherwise, if he received a 3.5% loan (reflecting inflation only) and got 3.5% raises, he could pay off the loan over 5 years using 4% of his salary each year ($2,000 in year one, $2,070 in year two, $2,142 in year three, etc.) to get back the cost of the care, 20% of his salary.
Many see this as the real cost of a loan when they sign the loan papers. However, I started to think about if there are any additional costs behind the numbers. For example, the cost of a payday loan is not only for the cost for the 1st two week period but also for subsequent periods because the principle is typically not be paid off in the first two weeks and additional loans are taken out until it is. This is similar to credit cards that charge 12% interest on $2,000 balance. The cost of the loan is not the $20 interest charge in the first month, yet the total interest paid (that can add up to $200+ if not repaid within a year) plus any late fees.
Yet, there are other costs that are hidden. For example, a loan reduces our flexibility that can relate in higher costs on our other financial transactions.
Future Loans – When we take out a loan, future loans may have a higher interest rates associated with them. For example, if we take a $300,000 mortgage that lowers our credit score because it is deemed that our debt to income ratio is too high, we can be charged a higher interest rate when trying to buy a $25,000 car because the bank fears that we may fall behind in payments.
Insurance – We all know by now that lower FICO score could increase our automobile insurance. However, I started thinking about the higher cost of needing lower deductibles. Many times, people forgo a higher deductible (or drop comprehensive coverage altogether) because they are living paycheck to paycheck and could not afford the cost of replacing their car if something happens (could they afford a $1,000 deductible if living paycheck to paycheck). Thus, they get a lower deductible, at a higher cost, to substitute for an emergency fund because it is hard enough to have one car loan let alone add another loan on top of it if their car got stolen or damaged.
Credit Cards/Pay Day Loans – If we are paying off a car loan, we are probably not saving (putting money away) for the next car or possibly even saving for an emergency fund. Thus, it is easier to slip into a situation where taking out a short-term high interest rate loan is needed because we were not in a position to save money. If we were ahead of the game, we could be saving a large down payment for the next car which adds another layer to any existing emergency fund. Thus, if something were to happen, there would be extra savings around (for next car) that can get through the situation if needed.
Opportunities – The more leveraged we are, the harder it is to make adjustments to our personal situation out of fear of impairing an already tight financial situation. For example, it is harder to quit a job (without another job in place) if there are too many loans to repay without enough savings to get through a few months of a potentially long job search. Or, if you want to start a business that needs 1 to 2 years to get off the ground, it is harder if you are maxed out financially.
I am not against loans. Actually, I took out a car loan because at the time I did not want to dip into my stock portfolio or savings because I wanted the flexibility to change jobs and possible buy a new home (did not want to use a large portion of my savings just in case I needed it). Yet, in 2 years when my situation changed, we bought a new home so I did not need as much in savings to pay a dual mortgage if I could not sell my current home. Thus, we were able to payoff the car loan early.
The point is that we need to be aware of our financial situation to see that if a loan is pushing us closer to the financial edge where the cost of that loan in more than the interest paid on it. The added costs are possibly higher because other financial decisions are dependent (possibly costlier) on what we do now (if we take on too much debt).