For most Americans, going to a dealership to pick out a new car is a special moment.
Usually, there is a reason behind it — a treat to yourself for getting a promotion, an upgrade for a growing family, or maybe just a mid-life crisis — and the feeling you get when finding “the one” is hard to beat.
But before you give in to your impulsive drive, it’s worth taking a look at the true cost of that new car smell.
First, be careful about framing
Would you rather spend $999 now on the new iPhone XS or only pay $41.99 per month for the next 24 months?
$1,000 out of pocket right now sounds like a lot! But heck $42 per month, that’s just giving up dining out once or twice a month. Easy!
Choosing the subscription-based method seems like it’s easier, but after it’s all said and done, you’ve actually spent more money than if you would have just paid for it upfront.
You need to keep in mind that auto-dealers will play the same framing game, but the numbers are on a much greater scale.
ONly $50 more per month
Let’s say you’ve used an online calculator and found that you could borrow $25,000 for around $466 per month on a 5-year loan at 4.5%, which fits into your budget. Keep in mind the total amount you’ll pay over the life of the loan is $27,964 ($2,964 in interest).
You go to your local dealership to look for cars in the $25,000 price range when a salesperson approaches you and asks, “what are you looking to spend each month?”. To which you reply, “around $450 to $500”.
Now that the salesperson has your “top end”, they begin showing you cars in the $27,000 and $28,000 range and will likely say something to the effect of, “look, you can $3,000 more worth of car for only $50 more per month? Is that really going to break your budget?”.
What they’ve done is shifted your focus away from the overall cost and toward the incremental change that it will have on the payment.
If you borrow $28,000 for 5-years at 4.5%, the monthly payment may only be around $50 more ($522 per month) but you’ll end up paying $3,320 in interest over the life of the loan.
Or just finance for longer
What can be even worse is if you stick to the monthly budgeted amount and the salesperson says, “You can always extend the term of the loan which gets you BELOW your target budget! In fact, you can borrow $29,500 for 6-years at 4.5% and the monthly payment will be around $468 which is right where you want to be at!”.
Quite the compelling story. But what the salesperson forgot to mention is that you’ll end up paying $33,716 over the life of the loan and $4,216 of which is interest. That’s $1,252 more in interest than if you would have stayed with your original amount.
Sadly, it seems like this scenario plays out often.
According to Experian, about 85% of new cars are bought with financing and the average loan term is 69.03 months. Research by R.L. Polk & Co. says that the average length of time drivers keep a new vehicle is 71.4 months — around 6 years.
So what happens at the end of the 6 years? Most people have become so used to having a car payment, they do it all over again!
The tradeoff
What are you really trading off when you continually borrow for a mode of transportation?
I would argue that you are missing out on years of compounding interest and eventually having enough money to spend your time as you please, for however long as that time lasts (AKA retirement).
For fun, let’s pretend that instead of spending $466 per month on a car payment for the next 30 years you contributed that to a Roth IRA. 30 years is the equivalent of owning six cars in your lifetime, which is the average.
Assuming a very conservative annual growth rate of 3%, at the end of 30 years you’ll have accumulated $272,234! Using a slightly higher growth rate of 6% and that amount jumps to $470,444!
Is that new car smell really worth almost half a million dollars?