Join Ken Boyd for an in-depth discussion in this video Financing a vehicle and a home, part of Setting Your Financial Goals.
- I went to a parenting class years ago. I remember something the instructor said: "It's better for children to make mistakes "and learn from them when the costs are low." You'd rather have a child learn that it's important to be honest with your parents at age seven, not age 17. The older you get, the more expensive the mistakes become. One big decision nearly all adults make is to borrow money to buy a car or a home or both. It's a big decision because the financial impact affects many years.
To start the conversation, let's define some terms. Principal represents the original amount you borrow. For most car and home loans, the principal amount is repaid over time, not all at once. In fact, your monthly car or home loan payment typically includes both principal and interest. Interest is the expense you pay on the amount you borrow, which is stated as a percentage. If you borrow 10,000 dollars at six percent annual interest, the interest expense for the year is 600 dollars.
So your first step is to borrow at the lowest rate possible. Home and car loans are considered secure loans. This means if you don't pay back the home or car loan, the lender has the right to take possession of the asset. They will typically sell the asset to recover the dollars they have loaned out to the borrower. The car or home serves as collateral for the loan. Whether you're buying a home or a car, keep in mind that you have the option of renting rather than buying.
For this video, leasing and renting mean the same thing. I mention that because the financial industry usually refers to leasing a car as opposed to renting a house. They both mean the same thing. In both cases, you might consider renting if you don't plan to stay in the home or use the car over the long term. If, for example, you're transferred to a city to work for two years, you might simply find a home for rent. People who prefer to drive a newer car may lease a car and turn it in for a new leased car every few years.
On the other hand, if you plan on using your car for six years for example, or plan on living in a home for 10 years, you'll consider buying. When you're a buyer, you own the home or car after you finish making the payments. At my house, we own a van that has 190,000 miles on it. We finished making the payments several years ago, but we still use it, the kids drive it. So we're getting use out of an asset that we own. Now keep in mind as you pay back principle each month, the total interest you owe will decline.
Say for example that your principle amount owed at the end of June is 10,000 dollars. Your July car payment includes 100 dollars of principle repayment. At the end of July, your new principle amount owed is 10,000 dollars less the 100, or 9,900. You now owe interest on 9,900, not 10,000. This brings up an important point. A point that will help you save on interest expense. Your car or home lender will provide you a schedule for your monthly payments.
That schedule will list each month's payment in the amount of principal and interest paid in each payment. Make sure that you have the ability to pay back your principle balance at a faster rate than the payment schedule lays out. The faster you repay principle, the less total interest you will pay over the life of the loan. In fact, the decision to repay principle faster can be connected to your investment decisions. As you finish this video, think about your current situation. If you need to replace a car soon, will you lease the next car or buy it? If you're in your 50s or 60s and no longer have kids at home, would you consider selling your current home and moving into something smaller? All food for thought.