Which Would You Rather Have at Retirement: An Old Chevy or $300,000 in the Bank?

Which Would You Rather Have at Retirement: An Old Chevy or $300,000 in the Bank?
by Richard P. Halverson

Here's out it works. Suppose you are about 30 years old and you just finished paying off your four-year old Chevy. As with most red-blooded Americans you now feel it is your right - if not your patriotic duty - to go buy another new car and finance it for four more years.

This may be good for the economy (and your ego) but it is not good for your financial well being.

Assume you would need to borrow $20,000 to buy a new car after your trade in. Assume, instead, you make the decision to keep the car you have been driving for four more years. Assume you decide to make car payments to yourself for the next four years instead of to the finance company. With a 9% APR those payments will run about $497 a month, just about $6,000 a year. Assume you invest that payment every month and earn 7.5% after taxes.

At the end of the next four-year cycle you are in for a pleasant surprise. Sure your car is now eight years old. Sure your kids make you drop them off a block from the school. Sure your Quorum President sat you down and asked searchingly how your employment was going. Sure the membership committee of your Yacht Club has you on probation. But you now have enough money to pay cash for a new Chevy and have more than $13,000 left over.

Now, assuming you have not become too attached to your new image, you can buy a new car and keep making the payments to yourself. Assume you go back on the four-year new car cycle. You can buy new cars for cash the rest of your life. And here's the payoff. Nine cycles down the road, when you are just retiring, you will have a four year old Chevy and over $320,000 in the bank. That will help. The alternative is the same four year old Chevy and a thirty-six year credit history of car payments. The credit history won't help pay for your retirement or the cost of a Church mission with your spouse.

The reason for this wonderful difference between a credit report and $320,000 is that the interest is going to you rather than the bank. And it is more than just paying that interest to yourself - it is the compounding effect of that interest over the years. Compounding means that this year you earn interest on your investment and next year you earn interest on your investment and on last year's interest and so on. The effect is small in the beginning but over the years it becomes very important. In this and many other examples it becomes more important than the original investment.

You may be wondering if I factored inflation into my calculations? No I didn't. And it is shocking to think that a car that costs $25,000 today will probably cost over $70,000 in thirty-six years. Of course, it is equally shocking to remember that same car cost less than $7,000 when your parents were going through these same calculations. I ignored inflation this time because as the price of new cars rises over the years so will the amount you will need to borrow and the payments you will need to make. If you increase the payments to yourself just like you would need to increase the payments to the bank it will work out the same in relative terms, meaning the $320,000 figure will be much higher.

Incidentally, in this little illustration I assumed the monthly payments would be going into a taxable investment account. Perhaps the real decision for you is between car payments and investments into a 401k or an IRA that are tax-deferred accounts. Many people are actually facing this situation. If this is the case for you the argument for getting into position to pay yourself is much more powerful. There are two reasons. First, money accumulates even faster in these tax-advantaged accounts than in regular taxable investment accounts. And secondly, if the decision is between your 401k and a car payment it is strong evidence you are not investing enough in your retirement. If you hope to have any car at all when you are retired you need to be investing in your retirement as soon as possible. (Please refer to last month's article Planning to Retire.)

I haven't even mentioned the peace of mind associated with not having car payments to make to a financial institution. If a financial emergency strikes in life it is easier to cope with if you do not have some collection agency yelling at you and threatening to repossess your car.

Of course, if you skip payments to yourself you want to be certain it is truly a certified financial emergency. Key to all this is the discipline to actually save and invest the money.

Church leaders are often counseling us to get out of debt. Their counsel is good. This can help. So, pay yourself, or pay the bank. When you retire you won't even remember the cars you did buy, let alone the one you didn't buy.

Oh, incidentally what you read here about cars is not just for professionals and you definitely should try it at home.

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