March 3, 2022

How Much Your Car Payment Is Really Costing You

A car payment is likely one of the biggest monthly expenses that most Americans face. According to Lending Tree, in 2021 the average car payment for a new car was $563 per month, while the average American takes out $34,635 in loans for a new vehicle. This is a lot of money to be paying on an asset that depreciates in value, and is sitting parked around 95% of the time. There are two issues at play here; 1) the purchase of a new car with money you don't have (debt), and  2) the price of the car you are purchasing. I want to tackle both of these and illustrate just how detrimental they can be to building wealth.

Car Loans: According to Nerd Wallet, the average interest rate for a prime borrower (credit score of 661-780) is 3.64% on a new car and 5.35% on a used car. Below would be the interest cost of a 60-month loan on the purchase of a new and used car depending on borrower credit:

Costs of Buying a New Car Based on Credit Rating

Costs of Buying a Used Car Based on Credit Rating

In short, the worse your credit, the more expensive your car payment. I will preface this blog by saying that some people simply cannot afford to buy a car in cash. If that is the case, then buy the least expensive car you can (that is reliable), and pay it off ASAP.

Now, let's look at an example of a Prime borrower (credit score 661-780) buying a new car and the monthly interest payment of $54. Although that seems feasible, those monthly payments will add up. By choosing to have a car payment and pay the bank interest, this person is forgoing savings and investment returns in the market which are usually put toward tax-advantaged retirement accounts for many. If this car buyer instead put that $54 in the market, assuming a conservative 7% return over 40 years, they would end up with $48,000! Although that's astounding, it's only half the problem. In those numbers, we are only focusing on the interest payments, we haven't even broached the actual cost of the car of $34,635. The biggest problem associated with buying a car with a loan is that it becomes much too easy to buy a more expensive car than you need. A $600/month payment doesn't sound like much, but that can be hundreds of thousands of dollars of retirement savings that you are forgoing. Let me show you:

For this analysis, I want to look at the difference between buying a well-maintained used car in cash, versus buying a more expensive car using a loan. I will assume that you have $15,000 saved up to purchase a perfectly good used car (which should be more than enough for most models). The astute consumer will purchase a car in cash and own it outright. The borrower will put that $15,000 down on a more expensive car, and finance the rest. This is a very generous assumption, as many individuals do not have $15,000 saved, yet still go out and buy the more expensive car, borrowing on the entire vehicle! Anyways, I will assume that the borrower is a prime borrower, and will round down the interest rate to 3.5% on a 60-month loan. I then calculate the 40-year opportunity cost incurred by that individual, which is the payment difference between $15,000 and the price of the car they bought, compounded at 7% (a conservative rate of return you would experience with your money in the market). The results are eye-opening in the graph below:

Opportunity Cost of Buying an Expensive Car with a Loan vs. $15K Cash

Looking at the above graph, it is not an exaggeration to say that if you are in your 20s or early 30s and you are buying a luxury car with a loan, you are likely making a decision that is costing you hundreds of thousands of dollars in retirement. If you are taking out a car loan of $30,000+ to make car payments and not putting the maximum amount in your retirement accounts, you are saying goodbye to hundreds of thousands of dollars in the long run all for the sake of buying a "nice" car! The above analysis is also using rosy assumptions of a 3.5% interest rate and assumes you are putting $15,000 down on the car instead of buying a used car for $15,000. For a young or middle-aged individual that is trying to grow their wealth, buying an expensive car is probably the worst possible financial decision that they could make. Keep in mind, the analysis above only takes into account a SINGLE car! If you decide to buy 2 cars that you cannot afford, or several of them over decades, you are likely saying goodbye to millions of dollars. For simplicity's sake, the above analysis also does not take into consideration the cost of maintenance that usually follows the more expensive luxury cars. Those numbers would also increase the above opportunity costs by tens of thousands.

So What?

The purpose behind this analysis was to show how detrimental an expensive car loan can be to your wealth over a long period of time due to opportunity costs. Both the availability and marketing of car loans entices many Americans to purchase cars that are way out of their price range because they accept a monthly payment that looks reasonable at face value. In short, a perfectly good used car will serve the same purpose as a luxury vehicle and could save you and your family hundreds of thousands of dollars. If an expensive luxury car is that important and valuable to you that you have to have it, then by all means buy the car! Just be aware of the decision you are making and what you are giving up in future retirement savings to own that vehicle. I would also challenge you to take a look at your car and acknowledge that it is a depreciating asset that sits still in your driveway most of the time. Why would you sacrifice hundreds of thousands of dollars (potentially millions on 2 really expensive cars) to have a more expensive depreciating asset sit in your driveway? There is a reason that every other commercial you see on TV is for a car. Americans are obsessed with them, and they are status symbols of wealth and privilege. However, there is a reason that very wealthy individuals sometimes drive the same car for years upon years. They understand the time value of money and choose to not put their wealth into a depreciating asset. They choose to minimize the expensive cost of car ownership and maximize contributions to appreciating assets like stocks, bonds, and investment real estate.

I hope this discussion shows that the total lifetime costs of expensive car loans are very significant, and that it is important to be aware of them before deciding to buy (or hopefully not buy!) an expensive car, especially at a younger age.

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