That much? Really?
According to Experian Automotive, 25% of auto loans are being made with terms of six to seven years, up from 10% four years ago. That longer payment term means that more and more shoppers are trading additional interest payments, upside down loans, and more importantly, potentially smaller retirement savings in exchange for that lower monthly payment.
How much smaller? Let's run the numbers.
According to TrueCar, the average cost of a new car is $31,252, up from $26,374 in 2003, and according to Bankrate the average interest charged on a five-year auto loan is just about 4%.
Now let's assume that Mary -- the fictional school teacher from my article on breaking out of paycheck to paycheck living -- puts 20% down on that new average-priced car, which means she'd be financing about $25,000 of that $31,252 price tag. Now let's assume that Mary has two financing options. She could finance the car for 4% over five years and pay $460 per month or she could finance the car for seven years, which would likely bump up her interest rate a bit, let's say to 4.2%, which would make her payment $344 a month. Since the seven-year loan is a lot easier on Mary's monthly budget, let's assume that she picks that option.
That decision means that Mary will spend $3,898 in interest over the life of that seven-year loan, or 48% more than the $2,624 in interest she would have paid on the five-year loan. Since most people tend to trade in their vehicle sooner than the length of these longer-living loans, it also means that there's a very good chance that Mary's vehicle may be worth less than what she still owes on it when she decides to buy her next car. But the biggest and most important risk to Mary's financial health isn't from higher interest payments or upside loans. Instead, the risk to her financial future stems from spending thousands of dollars of income every year on an asset that is virtually guaranteed to depreciate, rather than investing that money.
For example, if Mary invested that $6,000 down payment and those $344 monthly payments in a low cost S&P 500 mutual fund, and that fund returns the historical market average annual return of 6.5%, then Mary's retirement savings could be $45,914 bigger in seven years.
Keeping it in perspective
It isn't reasonable to expect that everyone will forego buying a new car in order to sock more money away for retirement. However, knowing that every dollar spent on a new car could mean less money available to you during your retirement may encourage you to keep your current car longer, or at a minimum make you wonder just how valuable that new car smell is. After all, the real cost of that $31,000 car isn't its sticker price, it's also the opportunity cost lost in not doing something else with your money.