One of the easiest ways to get into a costly paycheck-to-paycheck lifestyle, or what I call PTP mode, is to think in terms of monthly payments instead of total cost. Accepting monthly payments is always the best route, or so we may assume, because we get what we want RIGHT NOW at an ongoing monthly rate that fits well within our budget. However, there are two problems with this thinking: 1) Anytime we are paying for an item through monthly payments, there is an additional cost attached to securing that item before we have fully paid for it (in other words, we have to pay interest) and 2) If we’re not careful, we could develop a habit of accumulating items through monthly payments, which decreases the amount of money that we have left over for saving and investing and increases the amount we’re paying monthly to secure items before we have fully paid for them.
I dealt with #2 in a recent post, but here I want to deal with #1: The fact that thinking in terms of monthly payments can end up costing you more in the end. Let’s take a purchase that my Wife and I have been eyeing for about a year now as an example, a 27-inch iMac with Retina 5K display:
Look at that thing! My my is it beautiful! And it can be ours for the low low price of $1,799. Ouch! There is something that hurts about taking that much money out of my pocket for a one-time purchase, hence why we have not yet gotten this gem. But wait?! There is another option to obtain this beauty NOW! If I sign up for the Apple-branded Barclaycard, I can have this baby now AND not pay any interest for 18 months. Sounds like a perfect solution right? Monthly payments without the extra cost. Let’s read the fine print to find out. Per Apple:
Extreme Grace Period (ECP)
Did you catch that? Although I will be able to avoid interest if I pay in full within 18 months, given the structure of the monthly payments, I will not be able to pay for the iMac in full through monthly payments alone. Instead, there is likely a sizable lump sum payment that would be due prior to the end of the 18th month, meaning sooner or later a big wad of cash is coming out of my pocket.
What if I can’t pay in full before the grace period ends? No worries, I will just have to pay ALL of the interest that has accrued since Day 1 AND pay interest monthly going forward until the iMac is paid off. We’ve just witnessed one of the favorite tricks of credit card companies: The Extreme Grace Period (EGP) tactic. With an EGP, credit card companies entice people to buy now based on their good intentions to pay prior to the grace period ending. Unfortunately, it’s harder to predict what is going to happen financially over 6 months, 9 months, 12 months, 18 months, and so on, which means that taking the gamble that you will end up having enough money to pay later is just that, a GAMBLE! And guess who ends up winning that bet more often than not? Not you.
So knowing that the average person is unlikely to pay in full prior to the end of the EGP, let’s take a closer look at how much could be due as a lump sum at the end of the 18-month period. At the low end of 14.49% using a simple interest calculation on the full principal ($1,799), the accrued interest amount would be roughly $391.02, bringing the total cost to $2,190.02. At the high end of 27.49% using a simple interest calculation on the full principal, the accrued interest amount would be roughly $741.82, bringing the total cost to at least $2,540.82! These are simply examples – The actual interest amount would be affected by the monthly principal payments and the actual method by which the credit card company calculates interest, but this calculation gives a good ballpark estimate of the amount of money that would be thrown away by not paying prior to the end of the grace period. For the privilege of having this iMac now, at minimum, we would risk hundreds of dollars later.
It gets worse. Let’s say you fall on hard times and are not able to pay off the iMac for a full 12 months after the grace period ends (18 months + 12 months = 2.5 years in total interest). At the low end of 14.49% using a simple interest calculation on the full principal ($1,799), total interest over 2.5 years would be $651.59, bringing the total purchase price to $2,450.59. At the high end of 27.49% using a simple interest calculation on the full principal, total interest over 2.5 years would be $1236.36, bringing the total purchase price to $3,035.36. These examples highlight another favorite hope of credit card companies: Perpetual Payments. The longer you are unable to pay in full, the higher your interest costs would be. Indeed, credit card companies prefer that you never pay in full. They’re quite happy with you paying the minimum payment each month so that they can continue making interest off of you each month.
Save Up Instead
I am not picking on Apple by any means through the above iMac example. At least Apple does inform customers of the risk of taking on monthly payment prominently on their website. But this example is a great way to see rough estimated costs of taking on monthly payments. One such monthly payment will probably not do much harm, but take on several such monthly payments, as many people have done, and you’re now possibly talking about thousands of dollars each year being sucked away by interest on monthly payments for the privilege of having what you want now. It’s best to use monthly payments only for situations where interest costs are relatively low and saving for the full purchase price may be a bit impractical, i.e., for a house. There may also be cases where taking on a monthly payment on a short-term basis with a low interest rate may be acceptable, such as with financing a car (although I suggest saving up and buying a good used car where possible instead). In most cases though, unless there is a truly urgent need, it makes better financial sense to delay instant gratification and save up the money in order to pay for the purchase in full with no interest.
Unfortunately, I will not be purchasing this iMac anytime soon. Instead, iWait – one day we will have saved up the full purchase price and will buy this beauty with no regrets.