How to know if a large purchase is affordable
People often think only of the per-month cost when determining what they can afford, but that can be an expensive mistake.
Can you afford it?
It’s a simple question on its face, but the more you dig into it, the more complex it becomes. Affordability, like risk, is as much a “feeling” as it is a mathematical decision.
And when it comes to a large purchase, such as a vacation, a car, or even a home, something that you can’t just pay for out of your normal cashflow, this is a matter of serious importance. You get this one wrong, and you could be in a world of trouble.
So how do you determine whether a large purchase is affordable?
I can help you with that.
The two important questions
The decision of affordability can be determined by two primary questions. They are:
- How much does it cost in total?
- How much does it cost per month?
These questions sound similar, but they are different, and have very different considerations.
Why you need both questions
Obviously, how much something costs in total is important, but it’s not the only thing.
If something costs $100,000,000, you probably can’t afford it, no matter what deal you strike. However, it’s when you spread out payments that the unaffordable becomes potentially affordable.
For example, if something costs $100,000 dollars, but only costs $100 a month, that’s very different from something that costs $10,000 a month. You could probably pay the former monthly, but not the latter.
There are limits though. You can’t just ask a seller to let you pay a dollar a month for the next 8,333 years!
And even if you could, it wouldn’t necessarily benefit you, because how much something costs per month affects how much something costs in total. They are interrelated.
And the reason for this is interest rates.
Why the questions are interrelated
If you’re spreading out the payments of something, it’s almost guaranteed that you’re being charged a fee to do so. This is the “financing charge”; you are literally being “charged” to “finance” something. It doesn’t matter whether it’s a credit card, a car loan, or a mortgage; it isn’t free to spread out payments.
And this is where the questions of “total” and “per month” are interrelated.
Let’s take a fictitious $250,000 home with a mortgage at 5% interest. For the purposes of the argument, let’s assume you put 0% down ( which I don’t recommend, obviously).
If you take out a 15 year mortgage on this home, you’ll pay approximately $1,977 per month in both principal and interest. After 15 years, you would pay a total of $355,858.
If $1,977 seems too steep for you, perhaps you would consider a 30 year mortgage. That would mean that you would pay $1,342 per month. More affordable, sure, but your total over 30 years would be $483,141!
So for a $635 reduction in monthly payments, you would be paying an additional $127,283 in total!
Here’s a little chart I made showing how various options in payback time affect both the per-month and the total cost.
As you ramp up the payment term, the cost savings per month trails off a bit, but the total amount of money you pay grows much faster.
How you can decide
Most people focus on the per-month cost as a measure of affordability. This is a mistake. If you only focus on the per-month costs, then you are going to pay vastly larger sums of money over the longer term.
You need to instead look at the total cost of the purchase, and then find the per-month cost that you can afford that will minimize the total cost.
In the case of the mortgage above, I would want to see if you could afford the per-month cost of the 15 year. If not, what about the 20? Or the 25? Or the 30?
Or take a car loan. What’s the most you could pay per month to lower your total costs?
Finally, you could instead try to buy the thing outright and pay no interest charges at all. After all, that is the cheapest way to buy anything in the long run. It probably wouldn’t work for a mortgage, but what about a vacation? If you saved up and paid for the vacation, you could come home and not bring home any credit card debt.
Sellers aren’t stupid
Sellers often tout how much money per month something costs. They’re no fool; they know that a lower per-month cost is a higher overall cost.
They don’t have your best interests at heart. Over the long-term, the total amount you pay for things matters way more than your per-month costs.
Now, of course, if you can’t afford the per-month costs, then none of this matters. But beyond that, think about total costs. You can be sure that the seller certainly is.
Originally published at https://empathicfinance.com on June 6, 2022.