Without knowing the true cost of something you can blow through your budget in a hurry.
The increasing ability and ease with which we can pay for merchandise on credit is astounding. Not only can you pick up the latest gadget, furniture, car, etc. today at the expense of your earnings tomorrow, but the sales promotions to get you to make that sacrifice are also becoming the norm.
The biggest hit to your long-term budget is evident when we consider the price paid versus the true cost of an item. It can apply to any purchase, but we see it frequently with bigger ticket items like automobiles or houses. It usually looks something like this.
The House Example:
‘Hey John, I heard you just made a killing selling your home in Morgan’s Grant.’
‘I sure did Dave. Who knew that when we bought our home 20 years ago for $200,000 it would be worth so much today?’
‘Wow! I bought mine for $150,000 25 years ago. I can’t wait to see what mine is worth now!’
What neither John nor Dave realize in this case is that the purchase price of their homes is nowhere near the same price those homes cost them.
For simplicity sake, let’s leave any additional costs like maintenance, property tax, etc. out of the equation and just focus on the purchase price.
Twenty years ago the average interest rate was about 7.5%. However, those rates have also declined steadily over the past 20 years. Let’s assume their mortgage interest rate averaged 5.5% over the 20 years, that they put down 20% to avoid any CMHC fees, and, that they amortized the mortgage over 25 years.
Plugging those assumptions into this mortgage calculator, we can see that the total cost of the house for John was actually $332,987! (That’s $40,000 in down payment, $160,000 in principal repayment and $132,987 in interest payments). The true cost is nowhere near the $200,000 he thinks he paid for it.
The Car Example:
The same thing applies to cars.
‘Hey buddy I heard you just bought a sweet new ride!’
‘Yessir I did. Want to go for a ride?’
‘Wow! This thing is awesome. How much did it run you?’
‘I got a sweet deal. I only paid $30,000 with no money down.’
Again we can use an online calculator to help us. Plugging in the numbers and assuming a 4% interest rate, we can see that the actual cost of the new car was $33,564.
As you can see, the price you pay doesn’t really have anything to do with how much an item costs you; it is only the starting point. To get a true read on the total cost to you, you need to take into account all the interest you will have to pay as well (not to mention in some cases taxes, maintenance, etc.).
This is why it is so important to pay attention and not get swept up in the price tag of something. Adding up the thousands of dollars of interest we pay in our lifetime, we could instead fund a significant retirement pool.
Making wise choices, and sometimes waiting to make a purchase until you can reduce those interest costs, is just another way to do better with your money.
Wade Bedard, CIM®
HollisWealth, a Division of Industrial Alliance Securities Inc.