Regardless, it is always a great weekend with some BBQ, music, laughs, and thoughts about the future. Our oldest graduated from university this spring and is headed off to graduate school. Consequently, this past weekend, our thoughts turned to his transportation situation. As you can guess, he has heard the mantra, “Don’t borrow money to purchase a depreciating asset”, for much of his life. Well, he is a finance major and this weekend, we “ran the numbers” on my mantra. What did we find?
First, our assumptions were as follows. We looked at both the cost of borrowing from a bank for a car purchase and the alternative of saving for a later purchase in a money market account. The rates were posted on a nationwide bank’s website as 5.19% and 3.75%, respectively. We assumed a new car costing $25,000 with a rate of purchase price inflation of 3%, while we assume a 10.91% annual rate of depreciation for an owned vehicle, resulting in the car being worth half its purchase price in 6 years. Every six years, for forty-eight years, the car was replaced with a similar car, less the trade-in, residual value. What did we find?
To begin, the $25,000 car purchased with debt would require payments of $404.83 each month for 48 months at an interest rate of 5.19%. On the other hand, one could keep driving their jalopy and save to purchase a new car in six years. An inflation adjusted goal of $29,851 is the cost of the car in six years. At a savings interest rate of 3.75%, a deposit of $370.35 per month would be required – a monthly savings of $34.48 over purchasing the car with debt. Similar calculations are done for each of the eight, six year periods and then the present value of the savings over one’s life of car ownership is calculated.
If one uses the 3.75% as the rate at which one earns on their savings, the present value is equivalent to an immediate increase in your expected wealth of $19,683 or a future increase in your wealth, at the end of the forty-eight years, of $118,740. Not bad but, on the other hand, if you invest these monthly savings in an account, say your 401k or 403b retirement account, and earn 7% on your savings, the present value of the savings falls to an immediate increase in your expected wealth of $7,874, while the future value rises to $224,490. At 10%, the long-run average for equity investments, the future value is $529,122! WOW!
Bottom Line? Mantra prevails. Borrowing money costs you and limits your Financial Success.
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Robert O. Weagley, Ph.D., CFP(r)
Chair, Personal Financial Planning
University of Missouri
Columbia, MO 65211