If you fixate on a purchase's monthly cost instead of looking at its true, total cost, you've fallen into the monthly payment trap. While it's important to make sure that any purchase you want to finance will fit into your monthly budget, ignoring its total cost can set you back thousands in the long run. Here are the most common monthly payment traps that people fall into and how much they can cost you.SEE: Can You Live A Debt-Free Life?CarsIt's difficult to pay cash for a vehicle--even a modest, used car with a lot of miles can easily cost at least $8,000. But many people prefer to spend tens of thousands to buy new cars because they come with warranties and are perceived to be safer and more reliable. Auto financing is a common way to manage this expensive purchase that many people consider a necessity. However, when drivers borrow money to buy cars, they often don't look at the total cost of the decision, let alone the total cost of the vehicle including taxes, title fees, license and registration fees, insurance, depreciation, maintenance and repairs, gasoline and financing. They only look at the monthly payment, and they end up spending more on the car than they wanted to without ever realizing it.
Here's an example of how you might look at a 2012 Honda Accord Sedan LX purchase from a monthly payment perspective, and how that same purchase looks if you consider the total cost.Monthly PaymentPurchase price: $21,000Loan term: 60 monthsDown payment: $0Interest rate: 5%Monthly payment: $396.30 Total CostPurchase price: $21,000Loan term: 60 monthsDown payment: $0Interest rate: 5%Monthly payment: $396.30Total interest: $2,777.75Total cost: $23,777.75This simplified example only takes interest costs into account. To get a real sense of how much this car would cost you over five years, you'd need to factor in the other costs mentioned above: taxes, title fees, license and registration fees, insurance, depreciation, maintenance and repairs and gasoline. Fortunately, you don't have to do this math; Edmunds.com has a feature called "True Cost To Own" that will give you a pretty good estimate. It estimates the true cost to own for the 2012 Honda Accord Sedan LX at $41,566 over the first five years of the car's life. The biggest component of this expense comes from depreciation--the car will lose about half of its value in five years. MortgagesMortgages are such a tremendous expense that we have a hard time comprehending their total cost. Instead, people tend to focus on the loan amount the bank will approve and the monthly payment they can afford. But the total cost of a mortgage over its life will play a major role in your net worth. It could affect such major decisions as retirement and sending your children to college. Let's take a look at the difference in the purchase price, monthly payment and total cost of a $200,000 home loan.Mortgage amount: $200,000Mortgage term: 30 yearsInterest rate: 5%Monthly payment: $1,073.64Total interest over 30 years: $186,511.57Total cost: $386,511.57 The total cost to finance your home purchase isn't a secret--it's clearly disclosed in the documents you sign when you close your loan. But many people don't consider the full amount until they see this piece of paper--and even then, they may gloss over it. No one wants to walk away from the closing table after all the time and energy they've invested into shopping for a mortgage and a house.
This total cost doesn't even represent the true bottom line because it doesn't include insurance, property taxes, private mortgage insurance, maintenance and repairs or the transaction costs associated with buying and selling your home, like closing costs and real estate agent commissions. From a purely financial standpoint, borrowing money to buy a house may not make as much sense as we think it does. Credit CardsPaying only the minimum monthly payment on your credit card makes it difficult to accumulate savings so that you can start paying for things in full instead of financing them. It also encourages you to buy things you don't really want or need because you can put off the sting of paying for them until months or years later. Let's say you rack up $3,000 worth of purchases on a card that charges 18% interest. Here's what will happen if you only make the monthly minimum payment:Balance: $3,000Interest rate: 18%Minimum monthly payment: 1% of your balance plus interest ($75 a month at first, declining gradually each month)Total time to pay off: 222 months, or 18.5 yearsTotal interest payments: $3,923.08Total cost of your $3,000 purchase: $6,923.08 As bad as this scenario seems, it could be worse. Let's say your interest rate is 29% because you don't have the greatest credit history. Now how much will you pay if you only make the minimum payment?Balance: $3,000Interest rate: 29%Minimum monthly payment: 1% of your balance plus interest ($102.50 a month at first, declining gradually each month)Total time to pay off: 243 months, or 20.25 yearsTotal interest payments: $6,521.96Total cost of your $3,000 purchase: $9,521.96Do you really want to be in debt for almost two decades for whatever you spent that $3,000 on? If you justify your purchase by telling yourself you'll pay more than the minimum, it's true that you won't pay as much in interest and it won't take as long to pay off your balance, but it will still be more difficult to pay your credit card bill on a monthly basis and more difficult to meet other financial goals like saving for a rainy day, a down payment on a house or retirement. Your best option is to spend within your means, only go into credit card debt as a last resort in a genuine emergency, and pay off the balance as quickly as possible.
Home ImprovementsFurniture, appliances, remodeling projects--all of these can be financed and turned into a monthly payment. What will these purchases cost you in the long run? How much could you save if you paid for these projects up front instead of spreading the cost out over dozens of months? Let's consider a moderate-sized project: remodeling two small-to medium-sized bathrooms for a total cost of $10,000. And let's say that you finance this project the way many people finance home renovations: with a home equity loan. You could take as long as 25 years to pay it back, but we'll assume that you want a shorter loan term to minimize your interest expense.Amount financed: $10,000Interest rate: 8.5%Term: 10 yearsMonthly payment: $123.99Total interest: $4,878.28Total cost: $14,878.28Given this information, you have to ask yourself if remodeling your bathrooms is worth not $10,000, but $14,878.28. What else would you have liked to buy with that $4,878.28? Would you mind postponing your renovation for a while to save up the cash if it meant you could later afford another renovation with the money you didn't have to spend on interest?If you include the interest on your home equity loan as an itemized deduction on your tax return, the actual cost of borrowing this money will be slightly lower since the deduction will reduce your tax liability by your marginal tax rate. But borrowing the money, even at a relatively low interest rate, is still pretty expensive.Ongoing, Optional Expenses: Cell Phones and Cable BillsMaybe you've managed to stomach the idea of spending $100 a month for your cell phone or cable bill--but is it worth $1,200 a year? What about $6,000 over five years (and that's not even counting the likely increases in service charges over time)? Taking a long-term view of seemingly minor monthly expenses can help you evaluate how important these items really are to you, what else you could do with that money, and whether you're willing to downgrade to a less expensive option. In fact, downgrading might be a good way to save up for that bathroom remodel.ConclusionIf you can avoid falling into the monthly payment trap, the next time you need to make a major purchase you won't be wondering why you don't have the cash on hand to pay for it. The money you will have saved by examining the total cost before you buy and before making any financing decisions will give you more of a financial cushion and put you in a better position to come out ahead on your next big buy.
Originally posted on Investopedia.com