Credit is as credit does
Part 4
Editor's note - this is the last of a four-part series on credit, its importance and how to maintain it. Today, it is imperative your credit be the best reflection of you it can possibly be, so make sure you review your credit and understand what you see. If there are problems, follow these steps to correct them.
Keep Loan Terms As Short As Possible For Tremendous Lifetime Savings
As it has become more acceptable to use others' money to purchases just about anything, banks, finance companies and lenders of all types have "generously" sought to make your life easier by making those potential purchases more affordable through the use of extended terms. Extended loan repayment terms are popular because many of us are more concerned with the size of the monthly payment than with what we will pay in total for the good we purchase.
I will say it again - this is a tremendous mistake. The additional cost of a loan to you, one incurred by extending it for years longer than you should, is something that goes a tremendously long way to eating away at your efforts to achieve financial independence. Indeed, this circumstance is probably the number one impediment to wealth achievement for most people.
Let's look closely as to why extended loan terms are so damaging to your bank account. If you buy a car for $20,000 and finance the purchase for 36 months at 9 percent interest, you will end up paying a total of $22,895 for your vehicle ($20,000 principal plus $2,895 in interest). If you finance that same purchase with a 60-month loan (still at 9 percent), you will pay a total of $24,910 for the vehicle. It's the same car, only now the bottom-line price tag is more than $2,000 higher because you opted to extend the terms of your loan.
When you think about the number of cars one typically purchases over the course of a lifetime, it doesn't take long to realize the average person who finances vehicles for what has become the "standard" 60-month term is losing a lot of money that could otherwise go into investment accounts. Now, it is true that in the 36-month example, your monthly payment is about $220 higher than if you finance for 60 months, and it is that "savings" that so many consumers find appealing. However, this savings is actually no savings at all, and it is in your best interests to stick with the higher payment in exchange for keeping thousands in your pocket over the life of your loan.
This sort of thing goes on all of the time, with all types of loans. Look at the home mortgage. The choice of the "standard" 30-year fixed over the "less standard" 15-year fixed may well be the quintessential example of losing a significant sum of money by extending out the term of the loan. If you pay $100,000 for a home and finance the purchase with a 30-year fixed loan at 8 percent interest, you will end up paying about $264,000 for the house when it's all said and done! If you drop the loan term to 15 years, you will pay a total of about $172,000 for the home. This is a savings of more than $90,000!
Here's the real kicker in the mortgage example. Your monthly mortgage payment on the 30-year loan is going to be about $733; in the 15-year, it will be about $955 - higher, to be sure, but not so much higher that the 15-year becomes prohibitive. In fact, it's an increase of only about 30 percent over the size of the 30-year payment (not 100 percent which some mistakenly think).
The point should be obvious. By keeping loan terms as short as possible, you can easily realize a lifetime savings of well over $100,000. It is amazing, but even more amazing is how few people, even after learning the degree to which savings can be realized by doing this, still opt for the longer-terms, but lower-payments choice. Don't be one of them. There are many ways to increase wealth over the course of your lifetime, such as through the implementation of a diversified investment portfolio, and by taking a proactive approach to career advancement. Still, the best and first thing you should make certain you do to enhance your financial standing is to save money whenever possible, and keeping the terms of your loan as short as possible will go a long way to helping you save.
Avoid The Use Of Debt Consolidation Loans
Are you familiar with debt consolidation loans? These are the heavily advertised loans, typically offered by finance companies (as opposed to banks) specifically designed for people who are overburdened with consumer debt from multiple sources. A profile of a typical debt consolidation loan candidate is someone with thousands of dollars in credit card debt from many different cards and who may also owe a lot of money on department store charge cards and specialty cards issued by consumer electronics and furniture stores. The point of debt consolidation loans, as the name suggests, is to combine all of your outstanding consumer debts into one lump sum that you make just one payment each month toward the balance. Besides the simplicity of the arrangement, the real selling point of debt consolidation loans is they will also lower the total amount of money you have to pay toward your bills each month. In many cases, debt consolidation loans can cut your total payments in half or more. Who in the world of crushing debt wouldn't want that?
Unfortunately, consolidation loans are not the debt-relieving panacea they appear to be at first glance. True, they will make your life simpler, and should slash your total monthly payments dramatically, but let's look more closely. With a debt consolidation loan, the finance company pays off each of the debts you have with the various credit card issuers, furniture stores, etc., and you are left to pay the total balance back to the finance company directly. However, the kindness of this lender does not come without a substantial price. First, the term length of the loan will be several years. Additionally, the interest rate of the loan may be much higher than the average interest rate you were paying on your debts individually. Even if the rate is roughly the same, the fact that you are now making these payments for many years longer than you might have otherwise means the total amount of money you end up shelling out over the term length of the loan will be far greater.
Simply put, by amortizing your total consumer debt for years at a high rate of interest, the consolidation loan, while succeeding in cutting your monthly payments, means you spend thousands more in interest toward the repayment. These loans are popular because, sadly, most consumers care only about the monthly payment and they pay far less attention to what they will shell out in total over the life of the loan.
Have you ever wondered why that friend of yours, who always seemed to be of limited means, is able to drive that luxury sedan? Now you know. He did what lenders, car salesmen and other merchants whose reliance on the use of consumer credit is paramount frequently encourage - he "brought the payments." That is, more important than the actual price of the car, or even the total amount he will pay for the car, principal plus interest, was simply the size of his monthly payment. Lenders are perfectly happy to deal with prospective borrowers on the basis, because in order to keep the payments lower, they need only extend out the length of the high-rate loan for many years…and reap additional thousands of dollars in interest.
Another problem with debt consolidation loans is they can become the genesis of a "two-headed monster" that can easily devour careless, undisciplined consumers. By clearing up the balances on all of their other credit and charge accounts, they are now able to access those lines of credit all over again. Remember, the debt consolidation loan will pay off your existing debts, but it will not make those credit cards and charge accounts disappear. Frequently, consumers who utilize consolidation loans find themselves in a far worse bind than they were previously - as they begin to rack up new debt on the old cards, they must now make those payments in addition to the consolidation loan. If you do get a consolidated loan, at least destroy the cards and close out the accounts of each of the debts the consolidation loan is replacing. That way, you can safeguard yourself against falling into this financially deadly trap.
You will, however, be much better off to stay away from these things altogether. A preferable solution to your troubles than the debt consolidation loan is to apply the previously mentioned "lowest-balance" or "highest-rate" systematic payment method to your debt load. Simply arrange your debts either in order of lowest to highest balance or highest to lowest interest rate, and hit 'em hard, one by one. You will find approaching your multiple debts in this fashion will allow you to both eradicate them with great effectiveness and save thousands of dollars in the process.
Originally published in James Dicks: Buy*Sell*Hold magazine.