Ramit Sethi Says This Money Mistake Is 'Like a Child Eating Crayons'

This is what unsavvy people do, according to the author of I Will Teach You To Be Rich.

Here's a situation most of us have run into before: You're thinking of making a big purchase -- it could be a car, a piece of furniture, an iPad, or practically anything. You really want it, but you're uncomfortable with the price tag. There is, however, a financing plan available with much smaller monthly payments that you could definitely afford.

Financial expert Ramit Sethi has talked with many people who made purchases based on the monthly payment, and he says it's "like a child eating crayons." It's understandable when you're 6 years old, but not so much when you're an adult. All jokes aside, he makes an important point about a common financial mistake.

The problem with monthly payments

Monthly payments are every retailer and car dealer's best friend, for one simple reason: They take the focus away from the total cost and put it on a more budget-friendly amount. That tones down the impact of how much you're spending.

For example, a $2,000 jacket may be a hard no for you. But if the merchant will let you buy it for about $335 per month over six months, all of a sudden, that purchase gets much easier to rationalize. You start thinking about how much you love it and that the monthly payment isn't too bad. You're okay with spending $335, which is all you're really adding to your bills.

People use this sort of logic on themselves all the time. In The Ascent's study on buy now, pay later (BNPL), 45% of respondents said they used BNPL to make purchases that otherwise wouldn't fit in their budgets. And Affirm reports that customers of its merchant partners spend an average of 85% more when they pay with its BNPL plan compared to other payment methods.

These tactics work, which is why companies use them all the time. With a long-enough payment plan, it's easy to make a purchase look affordable. You might know that a $50,000 car is way too expensive, no matter how much you like it. When the salesperson says you can get it for $700 a month, that suddenly makes it seem manageable, as long as you don't think about the 72-month term and the $8,000 in interest.

Even if it seems reasonable at the time, you're still ultimately spending money you can't afford. You'll have more debt and less disposable income, both of which can hold you back on your financial goals. And if money gets tight, excessive monthly payments will likely be a decision you regret.

What you should do instead

Focusing on monthly payments is a bad idea. Ramit Sethi recommends that when making a purchase, you focus on the total cost of ownership.

The total cost is the full amount you'll pay over the course of your payment plan or loan, including any fees and interest. If there are other ownership expenses, like insurance costs on a car you purchase, factor those in as well.

This is the only way to fully gauge how a purchase will affect you financially. Monthly payments alone don't give you an accurate idea, because those will vary quite a bit depending on how long your loan is.

Sethi also says you should "zoom out of thinking about your expenses as monthly expenses and start thinking on an annual basis." The idea behind this is to take more of a big-picture view of your personal finance. When you only look at the short-term perspective, it's harder to see how much of an impact each decision has.

Imagine you're considering financing a purchase at $400 per month for 12 months. Maybe you can afford that each month, but zoom out and think about how a $4,800 expense will affect your other goals. Will you still be able to hit your retirement savings targets? Is your emergency fund where you'd like it to be? Most importantly, decide if you're still comfortable with spending $4,800, or if you're only considering it because of the monthly payment amount.

Sethi has plenty of quality money advice, and his recommendations here are spot-on. Don't put too much weight in monthly payment amounts. What matters for your long-term financial outlook is the total cost of what you're buying.