The Importance of Car-Buying Decisions
By: Mike Earl, CFP®, CPWA®
Some blog posts are more important than others. If I could shout through the screen to you, I would say: “This post is really important!” It’s not important in the sense that “Mike and Austin think this is important”; it’s important because the math shows us it’s crucial.
The second-largest annual expenditure for Americans is transportation (second to housing). If it’s the second-largest annual expenditure, it’s appropriate to say this category of spending should be a big deal in the world of financial planning.
Yet most financial planners rarely touch on this subject. Vehicle purchases are often an emotionally-charged decision, one that is significantly hampered by the tens of billions of dollars in advertising dollars spent by car companies in the U.S. each year.
The difference between excellent vehicle decisions and lousy vehicle decisions amounts to thousands of dollars per year. Conservatively, I estimate the average American married couple could easily save $4,000 or more per year from being more prudent about vehicle decisions. If that $4,000 of savings is invested for long-term growth in the stock market, you end up with $743,000! That’s at 8% growth per year for 35 years. It’s remarkable.
I’m not talking about driving clunkers your whole life. I’m talking about paying cash for cars, buying used (ideally at least 3 years old), and paying attention to reliability (Japanese over German) and fuel efficiency (sedans and hatchbacks over SUVs).
Here are some facts to provide additional perspective on the importance of vehicle decisions:
Americans spend twice as much on transportation each year as they do on healthcare. We hear a lot about rising healthcare costs (and rightly so), but we don’t hear a lot about rising transportation spending for ordinary Americans.
The average new car purchase price in the U.S. in 2017 was more than $36,000.
The average auto loan is now $30,032.
For the entire team here at The Wealth Group, vehicles are seen almost entirely in their utilitarian sense: a car takes me from Point A to Point B. We search for reliable, affordable used vehicles to safely transport ourselves and our families. It’s not a status symbol.
Let’s look at car purchases from the perspective of being an “investment”. What if Austin and I told you we had an investment opportunity for you that required a $30,000 initial investment that would be worth $12,000 in five years? Would that be something you might be interested in?
That’s what you receive from any new vehicle purchase. A new vehicle is worth 40% of its purchase price after 5 years. You are building in a guaranteed loss of 60% over 5 years, which equates to a compounded annual rate of -16.75%. And we’re not even accounting for maintenance and repairs, insurance, gas, etc.
You can understand why Austin calls vehicles “destroyers of net worth”:
Two scenarios should hammer home the impact of depreciation:
Scenario 1: You bought a $30,000 vehicle on March 15, 2013. That same vehicle would be worth about $12,000 today.
Scenario 2: You bought a $15,000 vehicle on March 15, 2013. Then, you invested $15,000 in a growth stock index fund (like we use for all our clients). In this scenario, today you have a $6,000 car and $32,220 in your growth stock index fund. In just five years, we see a wealth differential of more than $26,000 between those two scenarios.
More importantly, the $32,220 in the growth stock index fund will continue to compound in growth in the future, meaning the gap between the two scenarios will widen exponentially.
For those of you thinking $15,000 won’t get you much these days, there’s a shiny 2015 Toyota Camry with 41,000 miles for sale today in Minnetonka for $14,900.
The 2015 Toyota Camry: not exactly a clunker. You can find these for about $15,000 with a quick search.
And for the even more frugally-minded, there’s a 2013 Honda Fit with 45,000 miles being sold for just under $9,000 today.
Wealth-building is largely about managing trade-offs: we all have finite resources to allocate to various needs, wants, and wishes (and our wants and wishes are closer to infinite than finite). When people allocate too much of their income toward buying vehicles, it’s harder for them to build self-sustaining wealth.
Here’s a reasonable rule of thumb to follow for vehicle purchases: limit your purchase price to 20% of your personal gross income (i.e. not your joint income). If you make $75,000 per year, you are buying a $15,000 vehicle…and driving it until it won’t drive anymore.
Internally, the planners here at The Wealth Group each aim to limit our vehicle purchases to no more than 10% of our personal income. Admittedly, the 10% threshold is for truly frugal people committed to early Financial Independence.
Under the less stringent (but still very wise) 20% rule of thumb, let’s say a married couple has one spouse earning $90,000 and one spouse earning $60,000. Between the two of them, the 20% rule would mean their total purchase price for two vehicles would be $30,000. So, about $15,000 for each spouse’s vehicle.
Making sound decisions about vehicle purchases can single-handedly ensure your long-term financial success (assuming nothing outlandish going on in the other major areas of your financial life).
Because The Wealth Group, Austin B. Colby & Associates is independent of Raymond James, the expressed written opinions above are our own and not necessarily reflective of Raymond James’ opinions.