Beware of Financial Vampires

I define a financial vampire as an asset whose value rapidly depreciates shortly after purchase and continues to decline in value as time goes on. Common examples are vehicles, boats, expensive jewelry, and other luxury items. Every heard the joke that a boat is a hole in the water that you throw money into? It’s a perfect example of a financial vampire. The moment you walk away from the dealership or store, you’ve lost a huge amount of money that you can’t recover. In addition, expensive cars and trucks cost more to insure and repair, which compounds the financial losses even farther. There are many examples of items where “you get what you pay for”. Of course it makes sense that higher quality materials means better construction, better attention to detail, and a product that is more reliable and has a longer useful lifetime. But the car industry hasn’t really evolved that way. In fact, the most reliable, longest-lasting and lowest maintenance costs cars tend to be the cheaper ones! More expensive cars and trucks tend to focus more on optional amenities, detailing, power, and of course, status.

So what’s the price of that status upgrade over the long run, and how does it impact our larger investment and retirement goals? A 2017 Auto Reliability survey conducted by Consumer Reports asked subscribers to assess their annual maintenance and repair costs over a 10-year period by the make of the car. While luxury car manufacturers (BMW for example) would often have free maintenance costs for the first few years, the costs would skyrocket over the lifetime of the car. In the end, 10-year (2007-2017) maintenance and repair costs for “luxury” manufacturers like Audi, BMW, Jaguar, and Volvo were often over $1,000 per year, while lower cost manufacturers like Toyota, Ford, and Hyundai would hover near $400 per year. While $600 per year doesn’t sound like an incredible amount of money, keep in mind that these costs are in addition to the massive initial price difference, and subsequently your monthly loan payment. So let’s consider a simple example:

Car 1: 2019 Volvo S60 (new, $41,295 msrp), 10-year upkeep $10,000

Car 2: 2019 Hyundai Sonata (new, $22,500 msrp), 10-year upkeep $4,000

At first glance, you might say the 10-year difference in price is $18,795 + $6,000 = $24,795. A significant amount of money, but perhaps not crippling to somebody with a decent salary and stable job. But there is an additional opportunity cost loss here as well. Opportunity cost represents the benefit that is missed out on when one alternative is taken with money at the expense of another. In June we talked about the power of compound interest. In this example, the opportunity cost of a more upscale vehicle is very high, because we lost the opportunity to invest that money into our IRA, 401k, or brokerage account. Let’s just assume we paid cash for both the Hyundai and the Volvo in year 1, and then paid our annual upkeep costs for the next 10 years. If that $18,795 is invested immediately, and then we invest our upkeep savings of $500 each year, the 10-year value of that money is $44,364.41 (assuming “average” stock returns of 7% per year). Staggeringly, the 20-year value of that money is $94,663.31. That’s the true cost of picking a more expensive “status” symbol for your vehicle. Now throw in a 2nd car, a boat and a few more financial vampires into the mix over 20 years and you can quickly see how these costs can seriously inhibit your ability to retire when you want.

It’s one thing to point out that vehicles are financial vampires, but of course a good financial planner still needs to discuss a “plan” with their clients on how to approach buying their next car. After all, the average American commutes 27 minutes to work each day, and according to the U.S. Census Bureau, those times are increasing over time. Of course we need cars to get to work, to take little Jimmy to soccer practice, and to have the freedom to travel in a way that affords us the lifestyle we are accustomed to. But do we need brand new cars? From a personal finance standpoint, the answer is unequivocally no. Most online “car affordability calculators” suggest that the average person should keep their car loan payment at or below 10 percent of their gross (pre-tax) monthly income. Using those guidelines, a family which earns $75,000 per year can afford a monthly car payment of $625. While I agree that $625 is affordable for a family that brings home $75,000 per year, it’s certainly not optimal, and in my opinion a waste of money. As we noted above, paying high vehicle costs can siphon away your available cash, and subsequently your ability to retire early. So, the answer is to account for retirement savings or net worth when considering your car payment. A sliding scale allows wealthier people to “splurge” on more expensive vehicles without impacting their overall Car 2: 2019 Hyundai Sonata (new, $22,500 msrp), 10-year upkeep $4,000

At first glance, you might say the 10-year difference in price is $18,795 + $6,000 = $24,795. A significant amount of money, but perhaps not crippling to somebody with a decent salary and stable job. But there is an additional opportunity cost loss here as well. Opportunity cost represents the benefit that is missed out on when one alternative is taken with money at the expense of another. In June we talked about the power of compound interest. In this example, the opportunity cost of a more upscale vehicle is very high, because we lost the opportunity to invest that money into our IRA, 401k, or brokerage account. Let’s just assume we paid cash for both the Hyundai and the Volvo in year 1, and then paid our annual upkeep costs for the next 10 years. If that $18,795 is invested immediately, and then we invest our upkeep savings of $500 each year, the 10-year value of that money is $44,364.41 (assuming “average” stock returns of 7% per year). Staggeringly, the 20-year value of that money is $94,663.31. That’s the true cost of picking a more expensive “status” symbol for your vehicle. Now throw in a 2nd car, a boat and a few more financial vampires into the mix over 20 years and you can quickly see how these costs can seriously inhibit your ability to retire when you want.

It’s one thing to point out that vehicles are financial vampires, but of course a good financial planner still needs to discuss a “plan” with their clients on how to approach buying their next car. After all, the average American commutes 27 minutes to work each day, and according to the U.S. Census Bureau, those times are increasing over time. Of course we need cars to get to work, to take little Jimmy to soccer practice, and to have the freedom to travel in a way that affords us the lifestyle we are accustomed to. But do we need brand new cars? From a personal finance standpoint, the answer is unequivocally no. Most online “car affordability calculators” suggest that the average person should keep their car loan payment at or below 10 percent of their gross (pre-tax) monthly income. Using those guidelines, a family which earns $75,000 per year can afford a monthly car payment of $625. While I agree that $625 is affordable for a family that brings home $75,000 per year, it’s certainly not optimal, and in my opinion a waste of money. As we noted above, paying high vehicle costs can siphon away your available cash, and subsequently your ability to retire early. So, the answer is to account for retirement savings or net worth when considering your car payment. A sliding scale allows wealthier people to “splurge” on more expensive vehicles without impacting their overall progression towards a solid retirement. So I suggest that the average family limit their car payment to 5% of their monthly gross income or less, with a provision to increase that by 1% for every $100,000 they have in net worth (assets plus liabilities, as we discussed in earlier months). The easiest way to do this is to only purchase used cars. According to Carfax.com, most cars lose more than 10 percent of their value during the first month after you drive them off the lot. That’s essentially a 10 percent surcharge for purchasing a new car, with no added benefit other than the novelty of being the only owner. You might as well just light cash on fire! According to current vehicle depreciation rates, the value of a new vehicle will drop by more than 20 percent within the first year of ownership, then about 10 percent annually thereafter. Owing $20,000 on a vehicle with a Kelly Blue Book value of only $10,000 is an uncomfortable position that I see many of my clients in. Vehicles tend to depreciate in value faster than you can pay them off, and they are aptly named financial vampires because they literally “suck” away your free cash into a black hole of lost value.