One of the biggest problems that people have during tough economic times is losing sight of the long-term picture and focusing on just short-term survival. Primarily, I am talking about structuring loans so that they have the lowest payment possible. While searching for the best rate to lower your payment does make good financial sense, extending payments for longer than the use of the loan does not.
Most farmers remember the good old days of collateral lending. During that time, they could walk into a bank, tell the banker that they had land free and clear, and then walk out with a loan. It didn’t really matter why the farmer needed the money or whether the farmer could afford the payment—all that mattered was that the bank knew that it could get its money back by selling the property if it needed. The problem with that, though, was that if the farmer needed money again before the loan was paid off, he would have to pledge additional land to obtain a new loan. Often, farmers would get in trouble when all their land was tied up with loans or the payments became more than they could bear.
The problem illustrated above is most often the case when farmers want to buy a relatively short-term asset, such as a pickup, but does not want to have a payment for a short term loan. As quickly as pickups depreciate, long term loans rarely get paid down to the value of the truck when the farmer wants or needs to trade for a new one. Once the farmer trades in the truck, he still has to pay on the old loan and now has picked up a new payment.
For example, using today’s prime rate of 5 percent, let’s see what happens when a farmer wants to borrow $30,000 to buy a pickup. A six-year loan, which is often available, would have a payment of just over $480 per month. However, the farmer could use his land to secure a 20-year loan, which would put the payments at $200 per month. It seems like a great idea at the time to take the lower payments. However, in six years, that loan would be paid down to $23,900. Even if the truck is still worth $15,000 after six years and the farmer is going to buy another $30,000 truck at that time, he will have to borrow $15,000 to pay the difference in the trade-in and he will still have to make the $200 per month payment on the old truck loan for the next 14 years.
Improper loan structuring does not just involve using a real estate loan to secure a pickup. In fact, using a line of credit or an interest-only loan, which should be very short loans (one year or less), to buy a longer term asset will also cause problems. At some point, the principal has to be paid back, so if you only have the income to pay the interest, then you may have bigger problems when principal payments are forced on you in the future. Instead, these short-term loans should only be used when you will have an increase of income in the near future, such as the sale of the collateral, which can be used to repay the entire principal.
When you buy a vehicle, notice how car dealers often focus on the payment rather than the vehicle. They know that if they can get the payment to fit your budget today, you are much more likely to buy the car. However, as the examples above show, focusing only on the payment can be short-sighted and can lead to long-term problems. Instead, look at how long you plan to keep the vehicle or how long it will be before you will have another large expense, and if you cannot pay the loan back in that amount of time, it may be wise to find a less expensive alternative.
Lance Boyer is a Senior Credit Analyst/Financial Analyst with Central Bank in Lebanon, Mo.