Loan Period Wisdom for Reduced Debts

Problem debt is often caused by not matching the length of the loan with the life of the purchase. If loan lasts longer than the benefit then a replacement has to be bought and adds a new layer of debt.

Loan Periods – Some Simple Questions

A fewer simple questions will guide the borrower to a suitable loan length.

• How long will the benefit last or will the borrower enjoy the purchase?
• What is the life of the asset?
• How much value will the purchase retain over potential loan periods? Will it take the purchaser into negative equity?

Expensive Purchases and Suitable Loan Length

When planning typical large cost purchases which are often funded with borrowed money they should be considered against the above questions. For example:

House – long life, benefit and usually does not decline in value over the period of a typical mortgage. In this case the usual 25 or 30 year mortgage is appropriate.

Car – after five years the value may be less than the deposit on a new one and for many drivers it feels worn so the benefit is declining. A five year loan is probably a sensible maximum – if the car lasts longer then the purchaser can enjoy a loan free period.

Furniture or a new kitchen – Most people move every seven years or so; that  then should be the maximum period of any loan. After just a couple of years the value of the item at that point will be effectively zero so there is a strong case for keeping the length of any loan even shorter.

Clothes – a life of less than a year should be assumed; if they are fashion items then considerably less. At this point borrowed money no longer looks wise and such purchases should be made from everyday expenditure.

Holidays – like clothes the benefit is short and borrowing over more than the period between vacations will result in debt on top of debt. They should be saved for but if they must be purchased with borrowed money then it should be repaid before the holiday starts.

Expensive meal out or a party – a few hours. Never use borrowed money (for example an expensive credit card to spread the cost). By using saved money it will be enjoyed much more as there will be the anticipation before and lack of guilt afterwards.

Short Loans Buy More

The downside of keeping loan periods short is that the repayments will be higher or a larger deposit will be required. This may delay the purchase but, apart from not adding multiple layers of debt, the borrower will actually pay less in total due to the effect of compound interest.

Over the long term then the short-term borrower will actually be able to purchase more than if they had taken out longer-term loans!

A Final Tip – Treat Saving Withdrawals as Loans

Treat personal savings accounts as a loan company and repay withdrawals as a loan over a period as suggested here. To be rigorous one should repay oneself with interest as the “borrowed” money will not earn the interest it would have done in the savings account.