September 29, 2022
One of the most important financial concepts—and often the most overlooked—is opportunity cost. Calculating the opportunity cost of a financial move can help you make the smartest choices for your long-term security.
What you should always focus on is that every time you make a choice to spend a dollar on something, that is a dollar you no longer have to use for another financial goal. That is, there is an opportunity cost to what you have decided to spend your money on.
And what you spend on a car is one of the most troubling opportunity cost mistakes I see so many households fall into.
According to TransUnion, the average amount financed for a new car is now $40,000, and nearly 20% of new borrowers recently took out a car loan that had a payback term of at least seven years.
With an average monthly payment near $700 for a new car purchase, that’s a lot of opportunity cost. The fact that you are paying it back for at least seven years just adds to your cost.
Don’t tell me you need a car. I understand that. But when you are spending that sort of money and needing that long to pay back a car loan, that’s a sign to me that you aren’t just buying the least expensive car that meets your needs, but are likely borrowing more to have a fancier more tricked out car than you really need.
And that makes no sense. Especially if you aren’t on track with retirement savings. The less you borrow for a car, and the faster you can pay it off, the sooner you can free up monthly cash to add to your retirement savings.
Let’s say you buy a three-year-old used car and finance it with a four-year loan that costs you $450 a month, rather than buying a new car that costs $650 a month and you finance for seven years. Right off the bat, for the first four years, the less expensive option costs $200 less. So that’s $200 that could go toward retirement (or paying down high-rate credit card debt. Or building up your emergency savings.)
Let’s focus on retirement: Over the 4 years, contributing $200 more a month to your 401k or Roth IRA will add up to around $10,600, assuming it grows at an annualized 5% a year. Then if you leave that $10,600 invested for retirement, for another 30 years it will be worth more than $45,000.
That’s a lot of retirement savings based on paying less for one car. Put another way, the opportunity cost of spending $650 a month for the new car can “cost” you more than $45,000 in foregone retirement savings.
But the opportunity cost is actually even more. Let’s say you pay off the used car loan in four years. The way cars are built these days, it’s likely you can keep driving that car for at least another five or so years. That’s five or so years without a car payment. Sure, there will be more maintenance costs. But if you do routine maintenance, it is not going to cost you $450 a month. So you’ve effectively given yourself even more savings you can put toward retirement.
If you instead take out a new car loan for seven or more years, you are going to be making payments for a lot longer, and robbing yourself of that opportunity to save more.
So now you know: If you need a car that’s one thing. But you don’t need a new car or a nicer-than-necessary car. Your retirement may be riding on making the right decision.