Total Cost of Credit vs Monthly Payment

I read a press release the other day which points to the fact we need to be very careful with our finances. The subject of the release was home mortgages. A company was announcing the availability of 40 year mortgages for its customers. The stated purpose was to lower the monthly payments to make buying a home more affordable.

Whenever I hear the phrase “more affordable”, I put my hand on my wallet because the attempt to empty it will begin any moment. Almost never is that phrase used in relation to the total cost of financing. It is always used in reference to the size of the monthly payment, as in this example.

Let’s see what it really means. I did the math. A mortgage for a $100,000 home at 6% for 30 years would have a monthly payment of about $600 for principal and interest. You would pay about $216,000 over the life of the loan of which $116,000 would be interest..

A mortgage on that same home for 40 years would be at 6.25%, with a monthly payment of $565. The payments over the life of the loan would total about $271,200 and $171,200 of the total would be interest.

The forty year mortgage has a higher interest rate usually between.25 and .50 percent because the lender has his money at risk for a longer time Lenders are well aware that time is money. You should be as aware.

This higher rate coupled with the extra ten years of the loan, has the borrower paying 47% more interest, or $55,000 more over the life of the loan. Even with a lower payment that supposedly makes it more affordable to purchase that home. Sounds like a pretty good deal for the lender.

Another problem the borrower faces is building equity much more slowly in the beginning of the loan. The extra interest expense paid for the extended length of the loan prevents equity from building up quickly. All of this for a monthly payment that is only $35 less.

You need to think in terms of overall cost and not just monthly payments. The total cost is what you will give back to your creditors. The focus on the monthly payment takes attention away from the total amount to be repaid. You need to look at this with any indebtedness, car payments, personal loans, credit cards: figure the total cost, not just what you pay each month.

Youll begin to hear more about these loans Im sure. Think long and hard before you lengthen your indebtedness. The goal is to become debt free and to do it as fast as possible. Advise your families and friends to do the same.

c 2004 David Wilding