Foundations of Financial Planning: Cars
Americans fascination with the automobile has a long history. Americans fascination with money also has a long history. Unfortunately, these two historical American affinities can collide in such a way as to jeopardize or weaken the financial future of individual Americans.
Case in point: Rob bought a new car in August of 2014. Buying a new car went against everything he believed in when it came to cars. But the Great Recession left the used car market undersupplied and the new car market oversupplied. This was the only time in our lifetimes that buying a new car was cost effective.
Rob took out a 60 month loan on the car. Again, this was not his historically preferred choice but the interest rate was under 2%. The economic conditions at the time made the 60 month payment palatable.
The 60 months run out in August of 2019. Three more payments and Rob had $500 per month of additional disposable income.
Here comes the foundational financial planning question and lesson: what should he do with that extra $500????
For Rob, the answer is easy, immediately after the last payment is drafted from his bank account he will increase his monthly contribution to savings. This is what everyone who pays off a large bill should do. Put all or a large portion of the money that was going to the monthly payment towards savings. What type of savings will vary based on your individual situation.
Some folks should boost or create their emergency fund. Some folks might need to put it into their employer sponsored retirement plan. Some might want to put it towards college for kids or grandkids. Others just may want to put it into an account that is earmarked to be the down payment on their next car or repairs as the current car ages.
You may wonder what triggered the creation of this post. As we entered May, Rob began to getting emails and snail mail from the manufacturer of his current car. The correspondence went something like this:
- Your current payment is $501.
- We can put you in a brand new model of the same car for only $503!
- That’s only $2 more! (No kidding, the letter actually stated the difference between $503 and $501 was only $2!!!)
- 60 month term
- “Possibly no money out of pocket”.
Correspondence like this would not be sent if it wasn’t effective. For the consumers who fall for this sales pitch the financial results are significant. Instead of being free from the car payment, getting a boost to their disposable income and having an opportunity to save for the future, falling for this means another 5 years of car payments. It means fewer dollars saved for retirement, set aside in an emergency fund, or put away for college.
It does not take a leap of the imagination to understand that the person who falls for this once will likely fall for it their entire lives. We all know the people who have to buy a new car every few years. We all know people who roll over debt owed on one car into the loan on a new car.
For many people, car debt is a perpetual expense.
Let’s put this into dollar terms. Suppose Rob fell for this and decided to buy the new car. What is the opportunity cost in the form of lost retirement savings if he continued to do this when his money could have earned 5% had he saved it? What would $6000 per year ($500 per month) grow to at 5% over the following time frames?
- 5 years: $42,000
- 10 years: $89,000
- 15 years: $148,000
- 20 years: $225,000
Now, granted Rob would need to buy a car at some point that might reduce the ability to continue to save. However, raises and promotions over time also mean more income is coming in. In any case, you should be able to see the point. A perpetual car payment comes at a great cost and has the ability to create a negative impact on your financial future.
This is a wonderful foundational financial planning concept to share with your kids or grandkids.