## Tuesday, December 13, 2011

### Best Price or Lowest Payment, Part II

This blog deals with issues in adult life that we are capable of handling with elementary math skills, as taught in our Excel Math curriculum.

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
Now imagine that we have to pay a slightly higher price but we can choose from 3 different financing alternatives. Here's the first option:
•  \$110,000 at 6% interest over 30 years; 360 monthly payments of \$660 = \$237,600
A total cost of \$237,600 over the 30 years. Hmmm. What happens if I get a better interest rate?
•  \$110,000 at 5.5% interest over 30 years; 360 monthly payments of \$625 = \$225,000
This loan at one-half percent less interest ends up costing \$12,600 less.
•  \$110,000 at 5% interest over 30 years; 360 monthly payments of \$590 = \$212,400
This deal at one percent less interest saves me \$25,200 compared to the first deal.

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
A change of 1 or 2% on the interest makes a huge difference!
• monthly payments jump from \$590 to \$732 for \$142 per month increase
• overall cost jumps from \$212k to \$264k for \$52k increase
Shop hard for good loan rates, but don't overpay for the house or the loan "points".

SOME REFLECTION
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.