There is a basic guideline for financing a purchase; the term of the financing should match the useful life of the acquired product or service. Of course money is fungible, so this isn’t a hard and fast rule.
The logic is simple. Any financing is paid off before the asset is retired, allowing the owner to allocate a similar portion of their income to each new purchase. Typical examples would be a 30 year mortgage for a house, a 5 or 7 year loan for a car and paying cash for lunch.
The Los Angeles Times offers an example of mismatched financing in “Thinking Long Term“. The story describes a homeowner who consolidates her existing mortgage and home equity lines into a new 30 year fixed rate mortgage. This may seem rational since the homeowner has a lower overall monthly payment and a predictable fixed monthly payment. But she will be paying for her two new cars for 30 years!
The story offers these expenditures charged to her HELOC:
‘The 48-year-old mother of two had used the money for two new cars, kitchen renovations, investment in a family business and to help her oldest daughter through law school. She quickly ran up $155,000 in debt.’
The cars are probably 5 to 7 year assets, and the kitchen renovation probably has a 15 year useful life. When she buys her next car, she will still be making payments on these two cars. And probably the next car after that one, and maybe the one after that too!
Financing the investment in her daughter’s education and the family business for thrity years might be more appropriate. Of course, she was hoping “that her home’s double-digit rate of appreciation would bail her out if she had trouble repaying the loan.” I’ve heard that story somewhere before …
Best Regards, CR Calculated Risk