Yesterday I touched on the difference between getting the lowest initial price (good if you pay cash or are buying for the short term) or the lowest monthly payment (fine if you are financing for the long term). My comments here apply most directly to houses and sometimes to automobiles.
INITIAL PRICE VS LOWEST PAYMENT
How can paying a higher price save you money in the long run? It can ONLY IF you are able to get better financing and thus a lower total cost, OR if money is declining in value (inflation). It might be worth paying a bit more IF you can refinance later for less, or IF you don't plan to stay very long in your house.
Let's look at an example. We borrow $100,000 at 5% or 6% interest. Here's our cost:
- $100,000 at 5% interest over 30 years; 360 monthly payments of $537 = $193,300
- $100,000 at 6% interest over 30 years; 360 monthly payments of $600 = $216,000
- $110,000 at 6% interest over 30 years; 360 monthly payments of $660 = $237,600
- $110,000 at 5.5% interest over 30 years; 360 monthly payments of $625 = $225,000
- $110,000 at 5% interest over 30 years; 360 monthly payments of $590 = $212,400
What happens if I fail to get a good loan rate, and I have to pay higher interest, say 7%?
- $110,000 at 7% interest over 30 years; 360 monthly payments of $732 = $263,520
- monthly payments jump from $590 to $732 for $142 per month increase
- overall cost jumps from $212k to $264k for $52k increase
In the good old days we used to buy at the very limit of what we could thought we could afford, counting on inflation and time to raise our salaries and raise the value of the house. We gambled.
We bet on the interest rates coming down to reduce the cost of re-financing that hopefully would coincide with our greater income.
We gambled against interest rates going up, taxes increasing, losing a job, cars breaking down and/or divorce. All things that occur frequently, if not with certainty. Any one of these factors could make your deal collapse.
Even in "the good old days" people gambled and lost. But not too many people, and not too often.
Why? Among other reasons, Banks and Savings & Loan Associations kept us from getting too close to the edge. They made us put 20% or more down in cash (so we had a lot to lose), they talked to us about taxes and maintenance and other unanticipated expenses. They checked our pay stubs. They looked us sternly up and down, made us shuffle and stammer and invent good reasons for why we should get the loan. They didn't let us buy cars and houses at the same time.
PROCESSING or HOLDING?
In the past 10-15 years, it got easier. Loan applications were "streamlined" and less attention was paid to the property, or the buyer, or the ultimate holder of the loan. Everyone in the line was handling the paperwork with "tongs" or "gloves" rather than putting their fingerprints on it.
The loan was like a hot potato. Everyone expected to be in the house, or the loan, or the paperwork for just a short time, get paid well for their services, and move on without getting burned.
I call this processing. We were all gambling - everyone from top to bottom - both the naive and the sophisticated players.
We forgot that houses are also homes, and that we live in them as well as invest in them. Bankers forgot they were not just loan originators, but also in the business of holding loans over time, collecting the payments so they could pay interest to the folks dependent upon that income - making their house payments with the income. In my mind, this is holding.