A good friend, who knows about my passion for personal finance, recently came to me to kick around the idea of purchasing a brand new Mercedes-Benz for his family. I immediately attempted to explain how big of a long term financial error he would be making, especially considering that his family already owns two functioning vehicles.
I patiently explained the numerous negative impacts that financing a $45,000 vehicle would have on his family's long term financial well being. I recounted the effects of the depreciation of the vehicle, the crippling impact of such a large car payment, the opportunity cost such a big car payment on his ability to save and invest, and the psychological impact of purchasing this type of luxury item entirely on credit. Unfortunately, all of my arguments fell on deaf ears, and my friend has since decided to purchase a brand new, Mercedes-Benz SUV, that he intends to finance with a 48 month auto loan.
Because the goal of compounding returns is to provide just the kind of financial education that may prevent someone making this kind of a financial misstep, I'd like to take this opportunity to truly quantify the cost of my friend's purchase.
The vehicle's depreciation. As a general rule, a new vehicle loses 20% of its value in its first year. It also loses 15% the second year, 13% the third, and 12% the fourth. This will result in my friend's $45,000 car being worth $24,427.00 by the time the loan is paid off. After 4 years, my friend will have paid $49,743.36 (on a 48 month loan at 5% interest) for a vehicle worth $24,427.00. That's a cost of $25,316.00 for the privilege of owning a Mercedes-Benz.
The effect of a $1,036.32 a month car payment. Think of all the things you could do with an extra $1,000 dollars a month. Pay down debt, stash the money in your emergency fund, fully fund two Roth IRAs, the possibilities are endless. I bet the same friend who would thoughtlessly take on 1,000+ dollar a month car payment would be overjoyed by a 1,000 dollar a month raise.
The opportunity cost. My friend is 30 years old. If he were to invest $1,000 a month into an index fund instead of a car payment for 4 years, and stop contributions after four years, at age 60, the total value of this index fund would be $663,747.09. (Assuming a 10% annual stock market return)
The psychological impact. Making this kind of purchase is very dangerous psychologically. It creates the illusion of wealth. I hope, for my friend's sake, that he will not feel the need to continue purchasing luxury items on credit, causing a spiral of debt that could rapidly get out of control.
The final, long term cost of my friend's Mercedes-Benz: $689,063. Interestingly, this is a conservative estimate. I assumed he would be able to get a discount of $5,000 on the actual sticker price of $50,000, I did not factor in insurance costs, and I used the nationwide new car average of 5% for his auto loan. I wish I could convince my friend not to walk down this financial path, but his mind is officially made up. I hope he enjoys his $689,063 Mercedes-Benz.
For more financial tips and helpful posts, visit this week's Carnival of Personal Finance, hosted by Living Richly on a Budget.
Photo By: RicardoDiaz