We spend a whole lot of money without really thinking about this much, and also don’t think much about how little we end up saving. It’s time to think about things more.
We are as guilty as anyone for focusing so much on what we should do with the money that we set aside to invest and not enough on the supply side of this, our putting money aside to invest. It’s not that we are not aware of the importance of both, and especially the fact that it doesn’t matter what return you may get if you don’t manage to put money aside to invest in the first place, but this is a pretty narrow topic and there’s only so many ways you can tell someone that they need to spend less.
We don’t want to tell anyone that they need to spend less, we instead want them measuring the benefits of their spending with the benefits of not spending, where they may be in a better position to decide for themselves what the best course of action will be. This is where people who advise on personal finance often drop the ball, they do too much telling and not enough actual educating, like a parent would.
You don’t even teach your kids very much when you try this, as opposed to trying to get them to understand why savings is so important needs to be given its proper due. They may have some vague idea of the benefits, but these benefits compete with pleasures much closer at hand, and it’s much harder to compete with the present when the future is shrouded in darkness.
Whenever we are seeking to advise people to save more, this always cashes out to spending less, even though this is not always made clear enough. We may be told that we should at least have a million dollars’ in savings to buy a new car, like popular radio spokesperson Dave Ramsey tells his 16 million listeners, but plenty of people still buy them, and aren’t persuaded enough by Ramsey telling them they will be losing 40% of the value of these cars in the first couple of years.
That turns out to be nowhere near explicit enough for a lot of folks who may hear these broadcasts or read his articles or books, and while we’re sure this does work to get some people to do the right thing, these people deserve a better explanation than this.
We certainly applaud the efforts of anyone who wishes to get people to think more clearly about their spending, even half-hearted or vague ones, as our Western culture still has a massive addition problem, and the drug that they are addicted to is immediate gratification.
The downside of addiction isn’t that you don’t have a good time now, and in fact that’s the draw, to get high and not worry so much about tomorrow other than perhaps worrying where your next fix is coming from. The proper way is to consider not today or tomorrow but both, because tomorrow will come and we need to be not only maximizing our happiness now, we need to seek to maximize our happiness overall.
If we’re going to rely on just looking at depreciation costs, we at least need to work this out a little more than just throwing out numbers like 40% over the first two years, even though this is an effective enough deterrent for some. People do not even normally consider depreciation with these assets, even though depreciation is a very real cost that must be added to the other costs involved such as financing costs and maintenance costs.
If we don’t have much of an idea of how much something will ultimately cost us, other than just looking at how much a month we have to pay for the financing or lease payments, we’re not going to be left with much of a sense of what’s going on. The principal cost doesn’t even matter, as this comes down to the difference between what we pay for something and what we get for it if it is something like a car which we expect to sell one day, things that people may understand well enough if they are doing calculations for a business but the same people usually do a poor job of accounting for their own spending.
We’re happy though that Ramsey so eagerly points out how much of a ruse very low or no interest rates on car purchases is, where the seller capitalizes almost all or even all of the financing costs in the sales price, where you pay for this yourself of course but are tricked into thinking that you don’t. This is why we need to calculate market interest rates whenever we try to figure out the true costs here, which hardly anyone does, not that hardly anyone even thinks past the joy of ownership.
The More Defined the Benefits, the Easier They Are to Understand
We will break this decision down for you in more detail than just this though, as we must if we want to better ensure that we are acting sensibly. We’ll use buying a new car for $30,000 per year for 3 years at 5% and see where this takes us, what all the things are that we should be thinking about here from the view of actual economics and not from just its armchair.
This conveniently works out to $900 a month over 36 months. Interest costs are $2,400. You sell the car at the end of the 3 years, and it costs you $12,660 in depreciation, per Ramsey’s numbers, which we are fine with. This adds up to $15,060 over the 3 years or an average cost of $418 per month over the 3 years.
We already are providing more information than just telling people that they will lose almost half the value of the car over this period due to depreciation, even though cars don’t depreciate this much in terms of the loss of true value, this is because new cars are marked up so high.
Our deal was 0%, so we want to show you how this works as well. All they need to do to make this work is to sell you this otherwise $30,000 car for $32,400, and this even makes the car look better given it is now more expensive. You now pay the same $900 per month because that’s what the payments work out for this car at 0% with the financing charges included in the price versus your paying them yourself, in a transparent rather than hidden manner.
We need to compare this with an alternative, where person A buys it new and person B buys it from them and keeps it for 2 years. Sticking with Ramsey’s numbers, person B pays $17,340 for it and sells it 2 years later for $12,530. This varies among different makes and models as well as dependent upon other factors, but these averages serve our purpose just fine, because we are only out to show the average cost difference between these approaches which this does.
To keep this simple, we’ll assume that both are looking to take out loans for the time they plan on owning the car, where person B takes a 2 year loan out for this $17,340, but it makes no difference if they spread it out longer and use the sale proceeds to pay out the loan, because it’s the comparable difference in the principal amounts that are being financed that matters, as well as the relative depreciation costs.
This has both paying around $900 a month for the car, but the difference in payments don’t matter and we chose this to be able to compare interest costs. Person A pays $800 a year in interest costs, where person B only pays $459 per year. Person A pays $4,220 per year in depreciation, where person B only pays $2,405 per year for this.
When we add these up, person B saves a total of $2,156 per year over what it costs person A, and now we have a number we can use. We’re not done yet though, as we still need to get person B to see this as overpriced, where the fairly minimal psychological benefits are not seen as being worth anywhere near $2,156 a year, or to make it more easily understandable, an extra $180 per month.
We’re not finished yet though as we cannot just take this $180 at face value, because this money can be used to invest. Sure, we could spend it, and compare the happiness we would get from spending it on something else other than a little more newness with our vehicles, which does not even differ in any substantial way, but all discretionary spending must be compared to the value of investing it instead, which we will do with this $180 per month.
It’s time to put our loan calculator away and break out our investment calculator. We’re going to look at this over 20 years to see what the actual opportunity cost of these new cars actually is. We’ll use 11.4% for our average rate of return, what the Nasdaq has averaged over this time which include 2 big crashes. This index has done much better lately and you can even get a return like this or better these days with a hum-drum index, so this is very realistic.
Net of inflation and taxes, which we must take out because they do count unfortunately, we end up with $88,677, or $370 more per month, each and every month for this 20 years. Now we know the real difference, this much a month, when we add in returns.
Instead of just asking whether that new car smell is worth $180 per month, we need to wonder if it is worth over twice as much, $370 per month. Sitting with $88,000 in today’s dollars in 20 years isn’t anything we could retire on by any means, but it still spends. Choosing a gently used car over a new one isn’t going to take us anywhere near that far, but no one would expect such a thing, and few would expect this seemingly small matter to add up to so much.
We Need to Compare Savings with Spending Whenever We Spend
We need to do the same exact comparison with whatever we spend this on, whether that be on a new car, or, say, on entertainment. The entertainment may seem to only cost $180 a month, and we’ve calculated that we get lots more entertainment from this than from more car newness, but we need to make sure we are getting $370 a month worth of fun to make this the better choice over investing with it.
However your account balances change month to month, whether they go up or down, is always a calculation between income and spending, the income is the constant here, whatever it may be, and the spending is the differential part, the difference maker.
To be in a position to decide whether a certain type of spending is a wise comparative choice, we need to not only compare spending on one thing rather than another but also with not spending it at all, and calculate it’s future value in constant dollars. This is what economists do, and while there is considerable subjectivity involved in the ultimate calculations, actually using the numbers involved does help illuminate things and make these judgements easier.
The new car thing turns out to be an even bigger deal than meets the eye, even looking at how much they lose value in the first 3 years. This is not just about deferring pleasure, it is also about knowing how much more pleasure that is in store for us when we do.
People will always discount the future, and it’s rational to do a certain amount of this, as no one knows if they will even be alive at some point in the future, but we can’t discount something that we’re not even that sure what the value we’re discounting is.
We owe it to people to seek to explain the benefits of things as best we can, which always involves using concrete examples such as we have here and not over rely on the nebulous.
We need to arm people with enough of an understanding such that they at least have a basic idea of the opportunity costs that are presented to them on a daily basis, much of which remains under the surface of examination due to things like culture or habit.
The approach that our culture takes to spending is less like Dr. Pavlov, who sought understanding, and a lot more like his dogs, who were just taught to react to a combination of stimulus and habit. Overspending may be a hard habit to break, but it is much harder to do when you do not understand.
Like Ramsey, we feel that comparing newness of cars is a great way to teach people a few things about what they should be thinking about when looking to manage their spending, and need more like Ramsey whose explanations may be on the blunt side but blunt knowledge is better than none.
It’s not Ramsey’s fault though, as the appetite of his audience isn’t all that much, requiring the simplest of explanations that require no real thought. This is not unlike a kindergarten teacher’s curriculum being so limited by the capacity of the students. Better teachers can therefore help, but we need to increase our appetite for such knowledge before we can prepare ourselves to be more knowledgeable.
Ultimately, if we think about this enough, we will achieve a good balance between enjoying something now or enjoying even more in the future. This always comes down to being aware of how the portion of happiness that something provides diminishes with each unit of it, where we reach an equilibrium between being happy now and ensuring our continued happiness. Thinking more can make you happier.
It all starts with a thought. Maybe I should not just salivate when I see those new car ads and actually think about this more than thinking that I want it and can afford the payments. Maybe that extra depreciation isn’t worth it, and look how much less this ends up costing if you just do a one minute internet search and less than a minute with a calculator.
What if I saved the money? I wonder how much more I could get by putting this money to work for me to earn me more money?
Whatever I choose, I want it to be at least a conscious and informed choice. Perhaps the most that we can do for people is to get them to think about their finances more. Perhaps that is exactly what they need.