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Small Payments, Big Commitment

It's a good thing we're living longer, because we'll need all of those extra years to pay off our debts.

First came the 40-year mortgage, aimed at helping people in runaway housing markets maintain an affordable monthly payment. Now, as USA Today reports, consumers can finance their vehicles over longer terms than in the past, too. Toyota (NYSE: TM  ) Motor Credit and GMAC offer seven-year financing terms, and Ford (NYSE: F  ) Motor Credit has test-marketed some 84-month loans of its own.

The obvious attraction for consumers is that a longer-term loan reduces the monthly payment. And having to send fewer dollars to the bank each month means a lot more flexibility for the buyer. A savvy money manager might even come out ahead by investing those extra bucks. If, that is, you're not pouring them all into your gas tank on that new vehicle.

Another advantage? If you're concerned about what the future may hold -- for yourself, your job, or the economy -- a longer loan builds a small safety net into your finances. If you take out a seven-year loan but still make payments as if it's a five-year or three-year loan, you can always revert to smaller payments if you run into trouble.

Not all roses
But here's a warning sign: If you're stretching out your payments to make a purchase affordable, then maybe it's not really affordable.

Longer-term loans come with some drawbacks that can lead you to trouble, or at least a few misspent dollars.

  • You tie up your future income for longer. Those smaller loan payments mean more flexibility tomorrow, but it'll also take you longer to pay off the debt. Who wants to be paying on a mortgage into his or her 80s?
  • You can expect to pay more total interest, a lot more, with a longer-term loan. If you're looking at one of those 40-year mortgages, you'll probably also pay at a slightly higher interest rate. That's an expensive way to get a loan that's just slightly more affordable month to month.
  • With a longer-term home loan, it will take forever to build home equity. And if you're considering a longer-term car loan, you run the risk of going upside-down -- owing more to the bank than your car's worth. That's a problem if you plan to keep a vehicle for only a few years but want to finance its cost over a long span.
  • If you're looking for that payment safety net I described earlier, it will be mighty tempting to just pay the amount the bank wants, instead of the bigger payment you promised yourself you would make. (I can attest, from personal experience.)

To get a better idea about what that longer-term loan will cost you, ignore the monthly payment for a moment and calculate the total interest you will pay over the life of the loan. See whether those slightly smaller monthly payments will be worth what could be hundreds or thousands of dollars in extra interest.

If you really can't make the higher monthly payments that a shorter-term loan necessitates, then maybe you should rethink whether you can really afford your purchase at all.

Get more Foolish advice about borrowing money and see ...


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