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When you are looking to make a purchase, the best way to do it in most circumstances is to just pay for it out of your savings account. Sometimes, however, this simply isn’t possible because whatever you’re buying costs more than you have available to spend.
If you’re going to finance something by taking out a personal loan to buy it, lenders — or the salespeople selling the item — often try to get you to focus only on what you’ll pay every month. Unfortunately, doing that is a really bad idea. Here’s why — and what you should do instead.
Focusing only on monthly payments could cost you in the end
Only looking at monthly payments can make it seem as if a purchase is affordable, even when it really isn’t. That can happen if you finance the item over a very long period of time.
See, when you stretch out your payment over many years, each individual payment you make will be smaller — so it can feel as if the item is within your budget. But, ultimately, you are paying interest for a long period of time and the costs of that interest can add up to a lot. And you’ll be tying up income for a long period of time and preventing yourself from using it for other goals.
Between giving up the flexibility by committing your future income and making your already-expensive item cost more by tacking on a ton of interest charges, you could end up paying a big price for the purchase in terms of your financial security.
Say, for example, you wanted to spend $50,000 on your dream wedding or putting a designer kitchen in your house. Here’s what your loan might look like with different payment terms, assuming you get a personal loan at the national average interest rate (which is 12.17%, according to the Federal Reserve Bank of St. Louis):
| Loan Repayment Term | 3 years | 5 years | 10 years |
|---|---|---|---|
| Monthly Payment | $1,664.78 | $1,116.52 | $722.28 |
| Interest over time | $9,932.01 | $16,991.35 | $36,673.24 |
As you can see, you’re going to spend a lot of money if you opt for the longer loan term, even though it may put payments within your budget. You’ll also be limiting what you can do with your money for a decade, since you’ll have to send $722.28 a month to your creditors for that entire time. That’s a lot of money you can’t use to invest for retirement or meet other goals.
And in reality, since interest rates are usually higher on loans with longer payoff times, you’d actually end up paying even more for your long-term loan than these numbers already show. With a longer payoff time, you pose a higher risk to the lender — a lot can happen in 10 years, after all. But this is still a pretty good illustration of how a loan with a low monthly payment could make something seem affordable when, in fact, it’s actually really expensive in the end.
Be sure to look at the big picture to decide if something is really affordable
Ultimately, the only way to know if financing a purchase fits into your personal finances is to take a look at total costs over time and ask yourself if it is worth the interest cost — and time commitment — to get the item.
And remember, when you pick your loan term, if whatever you are spending on will no longer be bringing you joy by the time the last payment is made, you should not get such a long personal loan to buy it. You don’t want to be still paying off that loan long after your kitchen has become outdated again or your wedding is a distant memory.
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