By Ryan Campbell-Harris, Associate Actuary
The appeal of a new car, particularly a high-end car, can be great for a graduate who is starting out and earning well. But if you don’t fully appreciate the cost of credit, an expensive new car can set you back years.
In the following example, Millennials Tom and Jack, who earn much the same salary, can both afford to finance a car that costs R500 000.
Tom rewards himself with his dream car right away and finances it over six years. However, Jack decides to finance a car that costs R200 000, while saving towards his dream car. He instead chooses to invest the difference between the monthly payments needed to finance a car that costs R500 000 and his R200 000 car.
Both men will therefore be paying the same amount (R9 270) each month over the six-year period. However, Jack invests a portion of the amount, whereas Tom pays the full amount to the vehicle-finance company.
After six years, both men trade in their cars at a 40-percent residual value and use the proceeds as a deposit to buy the latest model dream car, which has escalated to R689 400 (assuming an inflation rate of 5.5 percent per year).
Tom finances the net purchase price via a finance company. Jack withdraws his investment, which has grown to R519 900 (assuming an after-inflation annual return of 4 percent per year.), and uses it to boost his deposit on the car. Tom, therefore, has to finance a new loan of R489 400 (R689 400 – R200 000 [40 percent of R500 000]) over the next six years, whereas Jack has to finance a loan of only R89 500 (R689 400 – R80 000 [40 percent of R200 000] – R519 900).
This example shows how interest can work for you or against you. You should aim to earn interest on an investment rather than pay interest on a debt. For six years, while paying interest on his car debt, Jack also invested R5 562 a month and earned interest.
Jack again saves and invests the difference between Tom’s loan repayment and his own repayment.
After six years, the men trade in their cars, at a 40-percent residual value, and use the proceeds as a deposit on a new expensive car. The price of the car has grown by the assumed inflation rate of 5.5 percent per year to R950 600.
Tom once again finances the net purchase price via a finance company, whereas Jack uses the proceeds from his investment, which has grown to R692 100 (assuming an after-inflation return of 4 percent per year), to reduce the payment required for the car.
However, this time the residual value of his car, R275 800 (R689 400 x 40 percent) and the proceeds from his investment are more than sufficient to buy the car without having to finance it. Jack has a balance of R17 300 ([R275 800 + R692 100] – R950 600), which he invests. Jack once again invests an amount every month that is equal to the amount that Tom has to pay each month for the newly financed vehicle.
Car and a return
At the end of the 6-year financing period, both men are driving the same type of luxury car. However, Jack has the benefit of enjoying both the car and a net investment of R1 192 500. After 18 years, when his first child starts university, Jack has just less than R1.2 million in the bank, which is more than enough to buy the next dream car using cash, or to help cover the cost of his child’s tertiary education.
Tom and Jack paid the same amount every month over the period. The only difference is that during the first financing period, Jack bought a cheaper car and used the balance to start saving for his dream car.
For Tom, the cost of rewarding himself with the dream car right away and purchasing it on credit, rather than purchasing down (R300 000 less credit) and saving up for the dream car, is about R1.2 million 18 years later in his career.
So, the next time you find yourself trying to work out how much credit you qualify for, think of Tom and Jack, and consider that you may be asking yourself the wrong question. Instead, ask yourself whether you are prepared to spend money today that you haven’t yet earned, because that’s what you’re doing when you buy consumer goods on credit.
More importantly, consider the cost of allowing that money to work against you rather than putting it to work for you.