Thursday, 7 May 2015

It happens every day at dealerships everywhere: a customer falls in love with a car.

The salesman runs the numbers and tells the buyer what monthly payment will be. The buyer doesn't think twice. They're confident they can afford the payment, and eagerly sign the loan papers.

Three months later, they find themselves barely able to make a car payment they never could afford, and never should have agreed to in the first place.

What can you really afford?

Many people have a similar experience when buying a house. A banker considers a buyer's income and tells them they could get approved for $400,000. The buyer falls in love with a $400,000 home and eagerly agrees to the monthly payment, thinking they can make it work. But in reality, between their monthly income and expenses, they can't afford the payment and end up in financial trouble.

Buyers frequently agree — often letting emotions overcome logic — to monthly obligations they are unable to meet. And the consequences can be devastating.

Save a down payment 

How do you avoid this mistake? By developing a smart saving habit that can help you save for down payments on large purchases while also making sure you can afford the monthly payment. Here's how it works:

Let's say you're currently renting for $800 a month, and you're saving for a down payment on a house. You're estimating the monthly payment on your house will be $1,200. Go ahead and put the extra $400 each month into a savings account. You'll be saving for a down payment, and you'll find out if you can afford the $1,200 a month house payment. Try doing this for at least 12 months prior to buying.

If you're unable to save that extra difference a month, you might want to consider a less expensive house, or wait longer to buy. A lot can happen in a year; maybe you'll be making more money, and saving for another 12 months will increase your down payment. You can use this method for any purchase you cannot pay for in cash and plan to finance, like a new car.

See what a difference a down payment makes

Speaking of cars, you don't hear much about people saving for down payments on them these days. In many cases, the value of a vehicle trade-in is the down payment. But if there's no trade-in, some buyers just finance the entire purchase price, which means they end up with a higher monthly payment and pay more interest over the life of the loan.

Let's say you're planning to buy a $20,000 car and finance the entire purchase price.

  • Amount of loan: $20,000
  • Loan term: 48 months
  • Interest rate: 1.99% APR
  • Estimated monthly payment: $433.82

If you saved $430 a month for 12 months, you'd have $5,220 to put down, and you'd finance $14,780.

  • Amount of loan: $14,780
  • Loan term: 48 months
  • Interest rate: 1.99% APR
  • Estimated monthly payment: $320.82

This is a simple example, and doesn't include taxes, insurance, and other fees. But you can see making a down payment lowered the monthly payment by more than $100. And since you are accustomed to saving $433 a month, you can afford $320.

Avoid emotional spending

"If you can't afford it, don't buy it." Just about everyone has heard an older relative utter these wise words. And while they made perfect sense 50 or 60 years ago, things are much more expensive today. Most people don't have $20,000 cash to pay for a car, but they still need a car.

Saving for a down payment by putting the estimated monthly payment into a savings account for at least 12 months could be considered the modern-day equivalent of making sure you can afford something. Sure, you'll still be financing, which most of our grandparents would never do. But you'll be doing it thoughtfully, and knowing you can afford it. What's more, if you have the discipline to save for 12 months, you're not making an emotional purchase, and you probably won't regret it.

Tips for saving and buying smarter

If you're interested in trying this smart saving method, here are a few tips:

  • Figure out what your monthly payment will be. Online calculators make it easy to get good estimate about monthly payments for homes, vehicles, and most other big-ticket items.
  • Open a new account exclusively for your "down payment" savings, separate from your primary checking and savings accounts. You can open either a regular savings account, or a money market account so you can earn more interest. Make sure you understand the fee structure for the account.
  • Save automatically. This is perhaps the most important step you can take to make sure you stick to your savings plan. Have the money automatically transferred from your checking account to your savings account every paycheck. You can easily set this up with your bank. With automatic transfer, you don't have to think about it, and you'll reach your savings goal faster.

 

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