A lot of financial planners spend a lot of time talking about how to invest money - trying to squeeze every last dollar of potential investment returns out of your investment portfolio. In contrast not nearly as much time is spent on spending habits - the very thing that will either put yourself in the position to be financially secure - or not. After all the first, and often forgotten step to being successful financially is to spend less than you earn.
Doctors Stanley and Danko wrote a great book on the habits of financially successful people called The Millionaire Next Door. In that book they look at various habits of millionaires living in the United States - including how they act as consumers. It's very interesting to look at the spending habits of millionaires on cars (with the sample millionaire having a net wealth of $3 million), as described in The Millionaire Next Door. They found that:
- More than 1/3 of millionaires purchased second hand cars
- 50 per cent of millionaires spent less than US$25,000 of their most recent car purchase
- More than 80 per cent of millionaires purchase their vehicle (rather than leasing/borrowing).
When you think about it, a car is the biggest purchase that you will make in your life that will actually fall in value. Sure you are likely to have more in superannuation and your own home, but all else being equal, your super and house actually appreciates over time. Not your car. It is not that you just buy one car as well. If you buy your first car at age 20, your last at age 75 and turn your car over every five years, you will buy 11 cars in a lifetime.
Are you spending $10,000 or 17 weeks of work?
It wasn't long ago that we were paid either by cash or cheque by our employers. This system had some benefits, particularly that it meant that we had a clear understanding of the work that had to be done to generate a pay packet. A combination of electronic payments and easy credit through personal loans and credit cards means that we often forget the value of work. For the average person it takes about an hour of work to end up with $15 in their pocket after tax.
That means that the difference between buying a $25,000 car and a $15,000 car is actually 17 full time weeks of work - with no money spent on anything else. Or, if the $10,000 difference was invested into a portfolio earning an 8 per cent return, the person who chooses the cheaper car could use the $800 a year of investment returns to take a whole week off work!
Depreciation - the hidden cost
Depreciation sounds like an impressive accounting term, however it is easy to understand in the context of owning a car - and it is the biggest cost of owning a car. Depreciation is the amount that your car falls in value over time. Unlike petrol, insurance, repairs and registration we don't notice depreciation - it just eats away at the value of the car week after week.
Let us look at a classic Australian family car. Based on RACQ calculations, the weekly depreciation cost of a new car is $105 a week - about half of the total running costs (rego, fuel, tyres, repairs, interest on the loan and insurance). Have a think about what that $105 means. It means that every week the average person earning $15 an hour after tax has to work around seven hours just to pay for the extent to which a new car had fallen in value. It doesn't matter whether your new car is leased, bought through a loan or purchased in cash the depreciation is unavoidable and significant. If, rather than purchase a new car, a consumer purchased a three to four-year-old one that was half the price, then the rate of depreciation would be roughly halved. Even if you doubled the RACQ estimate of service and repair costs for the older car (seeing as it is older), you will still be ahead by about $50 a week purchasing the second hand model. Those millionaires really know what they are doing!
Think about this on a cash basis. What if you had two cars in your garage - a brank-spanking new one and a three or four-year-old car. To use the new car for the week you had to put $105 into the ignition to get it started, and to use the older car you only had to put in $55 to get it started. \My strong suspicion is that most people would happily choose the slightly older car and start the week with an extra $50 (or three hours of work) in their pocket.
Here is the real clincher in my opinion. If a person buys a new car every five years, and given the rate of depreciation of $105.12 calculated by the RACQ, and if they buy their first car at age 20 and their last at age 70, they could have invested the depreciation of $105.12 a week at the rate of six per cent a year after fees, taxes and inflation and would have had $2.28 million in today's dollars by the age of 75.
They would only have ended up with the $2.28 million if they were prepared to forgo a car completely. If they either bought a second hand car, or a cheaper smaller car, that depreciation at the rate of $52 a week, they would have been $1.14 million better off by the age of 75. That is an extraordinary figure, and is before any other financial benefits of cheaper registration and fuel costs if you choose a smaller car. Further, this is only for one vehicle, with many families running two cars.
Suddenly you can see why many millionaires prefer second hand or relatively low cost vehicles. Or perhaps part of the reason they are millionaires is because they drive second hand or lower cost vehicles?
Borrowing or leasing - spending money you don't have and distorting your capabilities
It is interesting to see that 80 per cent of millionaires, according to Stanley and Danko, avoid borrowing to purchase their vehicle or using a lease. This is particularly interesting as, in general, you would think that leasing may have tax advantages for wealthy people.
When you lease, even with the tax advantages, you are still paying interest and fees to the financial services industry. Basically you are paying finance costs for an 'asset' that is falling in value. There is also a risk in leasing or borrowing that might be called a 'financial discipline erosion effect'. Basically, the low sounding loan or lease repayments tempts us into paying more for a car that we otherwise would.
How you spend has a great deal of impact on your ability to be successful financially. The cars you buy over time will prove to be the biggest purchase that depreciates in value, and being thoughtful about your decisions could be worth a cool million dollars or two!