Friday, May 20, 2016

The real cost of buying a new car

I am a fairly frugal person. An example of that is the fact that I drive a 15 year old car. I would likely keep driving this car until all is left is the steering wheel. The money I have saved always purchasing second hand cars would result in me being richer by hundreds of thousands of dollars over my lifetime. I do not see the point of buying an expensive new car every five years in order to get from point A to point B, when an older but reliable car can do the same thing for less.

Not everyone is like me of course, and I am totally fine with this. I sometimes realize however why some individuals would never accumulate a lot of money for their retirement. As someone in the accumulation phase, I have come to realize that the only inputs I have control over include:

1) The amount I can save and invest
2) The type of investments I choose to put my savings in
3) Maintaining low transaction and tax costs associated with investments
4) Sticking to my strategy even if someone is (temporarily) getting rich faster than me


There was a young fellow at my previous work, who had recently graduated from school. He received as a graduation present, an expensive German car worth something like $70,000. This person does not save money, but has decided that he deserves a shiny new car. In addition, he doesn't even invest in the company 401 (k) plan, because he doesn't trust the stock market. He is afraid to lose money in the markets. If I were in his shoes at the time I graduated, I would have taken the $70,000 in cash and invested it, rather than buy a shiny new and expensive toy. The opportunity cost of those $70,000 for someone in their 20s is huge. His base salary was $48,000/year. So you could say that he spent an amount equivalent to an year and a half of after-tax salary income for a new car.

I see several issues with his kind of thinking. The first issue is that with stocks, there is a high likelihood that if you hold a diversified portfolio, you are almost guaranteed to come out ahead after 20 - 25 years. In contrast, a car is destined to lose its value over time. If I were in this fellow’s shoes, I would have likely requested that the parents provide the $70,000 in cash or in the very least give them as a down payment on a house or apartment.

The second issue I see with this thinking is that this person is afraid of investing in companies, despite the fact that he was the top student in his business class. He knows US GAAP, understands business and finance, and is fluent in four languages. He works hard at his job, and is destined for a top management position within an organization within a decade. However, he does not know how to put this book knowledge to work in the real world. He is afraid to take a risk and earn a return, while taking a guaranteed loss on the purchase of the car. I think the lesson from this issue is that knowledge is important, but without using this knowledge correctly, you are wasting your talents.

The largest issue I see is that this young professional is missing out on the power of compounding. This is particularly shameful, given the fact that he likely has approximately four decades before he is eligible for Social Security. If he invested that $70,000 in a portfolio of dividend growth stocks yielding 3% today, he would be earning close to $2,100 in annual dividend income. Let's assume that these companies grew dividends at a rate of 4%/year. This is a very conservative estimate, since historical dividend growth has been somewhere around 5% - 5.50%/year.  If this young person managed to reinvest those growing dividends into more companies yielding 3% and growing dividends by 4%/year, he would be generating a nice $4,200 in annual dividend income in a decade. In addition, the value of those shares would likely be higher than the value of the car. And they would not cost much in terms of regular maintenance.

Even he put his money in low cost index funds (since he doesn’t know anything about investing), and earned 10% per year in total returns, he would end up with $758 thousand dollars in 25 years. If he could earn a 3% dividend yield on his portfolio, this would translate into almost $23,000 in annual dividend income. In forty years, he would have approximately $3.168 million dollars to his name, just from that $70 thousand seed amount. At a 3% dividend yield, this could translate to over $90,000 in annual dividend income. When you have a long period of time, and you can earn a decent rate of return, the power of compounding can turn large amounts of money into an even larger amount of money. I realize that the stock market do not and might not deliver a straight 10% total return every year, but historically, since 1926 stocks have managed to do that. Index funds also do not yield 3%, although constructing a portfolio of dividend paying stocks could do the trick.

The whole reason I am writing this article, is to share a lesson with the audience. It is important to learn from mistakes of others, in order for you to avoid making them. There is nothing wrong with buying a reliable car to take you from point A to point B. You do not have to live a miserly life, and make your own shampoo or toothpaste. A balance between spending and saving is important. But spending an amount that is equivalent to years worth of after-tax income on a car that will lose a large portion of its value in a few years is not a smart way to build your net worth.

Relevant Articles:

The importance of investing for retirement as early as possible
Expense Report - Last Four Months
How to retire in 10 years with dividend stocks
These Books Shaped My Investing Strategy
Investing Knowledge Accumulates Like Compound Interest

29 comments:

  1. Well, maybe his base was only $48K but his total compensation was $300K (bonuses and all). That might make it understandable.

    Paying more for a car than he earns in a year is indescribably stupid.

    Unless he's got a trust fund or something...

    ReplyDelete
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    1. Nope, the bonus was no more than 10% of the base

      Delete
  2. Awesome article D! Preach!

    As an aside, I enjoyed my couple of years making my own detergent and shampoo, taught me about economies of scale, means of production, and opportunity cost of time:)))

    Great article, thanks for posting!

    Joe

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    1. Hi Joe,

      As a shareholder in a bunch of consumer staples companies, i am biased against making own shampoo/detergent/ cleaner :-)

      Thank you for your comment!

      Hope all is well!

      DGI

      Delete
  3. This article is very interesting in that it strikes a cord with me personally. I got a $70,000 car after graduating law school from my parents. Now, after 6 years and in my mid-30s, I have sold that car (only got $25k for it) and leasing a hybrid car for getting from point A to point B.

    Looking back from the experience, now wiser and saving and investing a lot of my money, I don't think I regretted getting that fancy car instead of $70k cash from my parents. It was so much fun enjoying a fancy convertible car in my late twenties. Can't say I would have the same kind of fun later in life with the same car. But all in all, the whole experience also led me to become wiser with money now and want to save and earn more money. Hindsight is always 20-20. Investing the $70k would have made a lot more financial sense. But I'm not sure I would get to where I am now if had driven a crappy car all these years. To get to where I am now, I thought the whole experience was invaluable lesson for me.

    ReplyDelete
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    1. Well, a new reliable car could have been purchased for under $20k, which could perfectly move someone from point A to point B. That 50k difference is a very high opportunity cost

      The other point is that after a while, the "excitenent" of a big purchase wears off - but the consequences stay.

      I am glad you have tried to learn from this experience.

      Delete
  4. I figured out the same thing a while ago. The difference between the people out there with money for retirement and the ones who don't are new cars. When you add up a $500+/month car payment vs driving a paid off clunker, the opportunity cost is incredible. Saving $6k/yr for 40 years and getting 6% returns gives you $1 million. You can buy whatever car you want at that point, and pay for it with the income from the nest egg.

    ReplyDelete
    Replies
    1. Yes, the point of the car is to get from point A to point B. Paying too much for cars, houses could set one back. Unfortunately, the advertising industry is out there to sell sexy concepts such as expensive cars.

      Delete
  5. Car is the worst asset you can buy since as soon as you drive off the dealer's lot, it has lost half of its values. :)

    You're totally right that this fellow would be better off investing that $70k instead of spending it all on the car. But people need to learn the hard way right? I'm glad when I graduated and started working I participated in the company RRSP matching and employee stock purchase plan when I was eligible.

    ReplyDelete
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    1. Looks like you are doing quite well, with almost $13,000 in annual dividend income in your early 30s.

      The point of this article is to learn from the mistakes of others, so that we don't repeat them. Life is too short already, so we cannot afford to repeat the mistakes of others. We need to make our own unique mistakes to learn from :-)

      Delete
  6. Great advice, and always good to see it in writing to remind you that you are on the right path. My car is 11 years young, and I love not having a car payment. I would be investing a lot less if I did have one.

    Anyway, I had to laugh when I saw your comment about driving your car until only the steering wheel is left. Made me think of this clip with the late John Candy from "Planes, Trains, and Automobiles":

    https://www.youtube.com/watch?v=ZKtFIgmoqoI

    ReplyDelete
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    1. Ha, that is an awesome clip.

      The article was of course figuratively speaking - if the car is no longer safe to drive, it is to be disposed of. However, once a reliable car is bought at a reasonable price, it can last a lot of time. That money could be used to save and invest. Otherwise, if one gets a new car every 3-5 years, they are doing their future selves a disservice

      On the other hand, older cars deter gold diggers :-)

      Delete
    2. Haha I love that movie and scene.

      I try to tell this to my clients all the time. I even wrote about it myself that vehicles hold people back financially, but the majority just can't understand it. I usually get looked at like I'm crazy when I tell people they need to rethink their vehicle decisions. It's an uphill battle that's not easily won.

      I had a friend with a similar situation where they received an inheritance of $80k. Spent it on a car despite my best efforts to convince them otherwise. I really felt like I failed big time on that one and I took it pretty hard. But it taught me not everyone can be convinced no matter the info presented. Sometimes they just want to do what they want.

      I've never driven a car younger than 7 years. But I always kept it clean and running well. People were always amazed at the vehicles real age. My current vehicle is from 2002 and it looks cleaner than most cars 4 years old. I never had a car payment and it's been a true cornerstone in allowing me to build my wealth way more rapidly than all the others in my age and income cohort.

      Delete
  7. Of course, just because he doesn't invest in the stock market doesn't mean he doesn't invest. There are many investments that can be made that don't involve stocks and bonds.

    ReplyDelete
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    1. The expensive car is a symptom of life full of excess. That person wore expensive clothes, bought new electronics, and per my observations spent most of their paycheck on dining out, travel, at the casino, on renting an expensive apartment etc.

      It is quite possible they saved some money in the bank. But they spent most of their income, and developed expensive tastes

      Delete
  8. Great article DGI! I was just talking to one of my new co-workers today and he is planning on purchasing a new $50,000 truck despite the fact he has $50,000 in student loans. I told him to consider something like a used plug-in Toyota Prius for 10-11k why gas prices are low and save yourself a years salary and a tank of gas every week with the truck. Unfortunately he wouldn't even consider the idea but I did my best to 'steer' him in the right direction. Anyways, thanks for what you do on this website!

    Ryan

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    1. Thank you for reading Ryan. It is unfortunate that your friend will get themselves in a financial hole they would never get out of with a $50k truck loan and $50k in student loans

      A used Toyota which is stil under warranty could b bought at a reasonable price, and driven into the ground

      Delete
  9. What if everyone saved and invested? Take comfort in people spending their money in foolish ways, you're the beneficiary.

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    1. Unfortunately, this will never happen. But i do like to learn about mistakes of others, so i minimize errors on my part

      Delete
  10. I'm only 27, my father God Bless him, quietly maxed out my Roth IRA while I was in grad school and college. He's given me a huge head start by using his own dividend income to fuel my dividend machine. In 20 years, I hope to pay it forward for my son. Time is your ally!

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    1. Mitchell, that is an awesome story. Your largest asset has been your ability to compound money, tax free, for several decades. I am more than confident that you will reach your financials goals much earlier than your peer group

      Delete
  11. Like with everything, there are exceptions. Buying new is fine if you buy a cheap, reliable car and run it until it dies.

    I have a 16 year old Honda Civic, that I originally bought new. 16 years later, the paint on the roof is fading, the bumper has rust, and the AC doesn't work; but it still gets me from point A to point B safely, and that's all that matters.

    I have done calculations, and overall I have saved money since I would have probably had to purchase 2-3 used cars over this car's lifetime.

    Whenever my current car dies, I plan to buy another new, cheap, reliable car; and drive that one for hopefully another 15+ years.

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    1. I agree with you for the most part. If you do not overpay for a car, and buy a reliable vehicle, you will have a lot of extra money to allocate towards savings and investment. Your future self will be happy with the results

      Delete
  12. My man. I put $13,000 total into two used reliable vehicles from 2002 to 2016. Reading this reminds me of myself. As I watch others drive around in their $30,000 - $50,000 vehicles I drive my older vehicles while maxing my retirement savings and my taxable savings. I like putting money in things that will increase in value to provide for my retirement rather than the thrill of diving a nice vehicle today. I'd rather retire at 50 years old driving old Honda Civics than to retire at 65 driving a nice Lexus. :)

    ReplyDelete
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    1. I love it when readers understand that the real price of buying an expensive object such as a flashy car is a decade or two of extra work at the office, in a job you may or not truly enjoy. And that is an expensive price to pay, since our time on this earth is sadly very limited

      Delete
    2. Yes sir, I can't agree more!

      Delete
  13. The thing is, it is entirely possible to get a pretty decent and flashy car (if one so desires) in this day and age AND still have a sizable amount left over for investing. That's especially true in regards to luxury cars, which see their values absolutely plummet. Armed with $20k, one can get into quite a lot of car, whether flashy or reliable beater and use the remainder that in this case, is the equivalent of an entire year's salary to fund anything else mentioned in this article. Realistically speaking, the vast majority of the population is clueless in regards to cars, so many will easily think that a clean specimen a decade old is brand new (and cost a LOT more than it really did!) solely due to the ornament on the hood. But then again, if everyone were to start acting rationally like that, the pool of used luxury vehicles would also shrink...

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  14. a 10% yield every year is defiantly on the high end. doesn't the market avg 8% including dividends since 1926?

    ReplyDelete
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    1. The article was talking about a total return of 10%/per year, not a 10% dividend yield. The tr gas been close to 10% since 1926, not 8%

      Delete

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