The Hidden Cost of Financing Can Be A Killer
Posted on July 20, 2007
I was recently taken task over an example I used to explain the difference between saving for a major purchase instead of financing it. The example, which is on page 33 of my book Weekend Millionaire Mindset: How Ordinary People Can Achieve Extraordinary Success, asks the question, “Would you believe you can drive a Chevrolet or a Cadillac for the same money?” (I used this example because nearly everyone makes a car payment.)
Following this question there is a chart in the book that shows the principal and interest (paid) breakdown (the amortization) of a 60 month loan Mr. Ordinary used to purchase a $22,000 Chevrolet. Next to it is the principal and interest (earned) detail for an investment account in which Mr. Financial Independence made the same payment for the same number of months. At the end of 60 months, Mr. Ordinary has a 5 year old Chevrolet and no money. Mr. Financial Independence, who made the same payment for the same number of months to an investment account has over $34,500 and could pay cash for a new Cadillac if he so chose.
When I mentioned in an article that I had used this example in a Junior Achievement program I gave to a group of sixth graders, a reader sent me an email that read, “Your comparison of a 60 month loan for a Chevy to saving up for a new Caddie conveniently (disingenuously?) disregards the inherent utility of the Chevy. The purchaser would have had transportation for those five years. Your analogy works only if the person had absolutely no use for the vehicle in the first place � i.e. had another serviceable vehicle � or otherwise would incur zero transportation costs as a result of forgoing the Chevy.”
When I tried to explain to this reader that just because we all have transportation costs and probably always will, trying to use the fact that you get to drive the Chevy for 5 years to justify financing the purchase misses the point entirely. What’s wrong with driving an inexpensive used car in the beginning while you save for the new one? In my example, Mr. Ordinary got a $22,000 vehicle for his 60 monthly payments, while the same 60 monthly payments would allow Mr. Financial Independence to get a $34,500 vehicle. The difference between the two is $12,500 and this is the price of impatience�of having to have it now.
If you divide the $12,500, which is the combined total of interest paid by Mr. Ordinary and interest earned by Mr. Financial Independence, by 60 months, it calculates out that it would cost Mr. Ordinary over $200 per month more to drive a Chevrolet than it would Mr. Financial Independence to drive a Cadillac. Paying that much more to drive a Chevy than a Cadillac seems to me to be significant enough to make anyone stop and think.
I figured this out more 30 years ago and I haven’t paid a dime of interest on a car loan since. Does that mean that I never financed a car? No! Like practically everyone else, I financed my first car purchases. What I did that was different from most people, was I kept making the payment to a savings account once a loan was paid off and gradually I worked my way out of having to borrow money to drive.
Unfortunately, most people who finance cars keep trading up before their current loan is paid off and roll the balance into a loan on the newer vehicle. Either that, or as soon as they make the last payment, they take the money they were paying on the car and spend it on something else so that when they need a new vehicle, they have to resort to financing again.
Here’s a tip! If you’re currently making a car payment, don’t despair. You will have transportation costs for the rest of your life, but there’s a way you can ride better for less. It does; however, require a bit of restraint and patience. The first thing that you need to understand is that the interest you pay on car loans won’t transport you a single mile. All it does is drive up your cost of getting around. With that thought in mind, here’s what you can do.
Resolve to keep your current vehicle after it is paid off. When you write that last check to pay off the loan, don’t start thinking about going out and trading cars and don’t stop making the payments. Just stop making them to the bank. You’ve become accustomed to not having that money each month, so set up an investment account and keep on paying it. You’ll see that you can save enough for the next car much quicker than you can pay it off if you finance it.
If you can bite the bullet and do this one time, you can then continue it for the rest of your life and always pay cash for your vehicles. In the above example, the difference of $12,500 over 60 months equals $100,000 over 40 years. I used this example of financing a car because it’s familiar to everyone, but the same principle is true for financing boats, motor homes, recreational vehicles, big screen televisions, computers, and most other big ticket items. It’s a sad fact, but most Americans pay enough in interest and finance charges over a lifetime to become millionaires if the money was properly invested.
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