CNBC recently published a story on the habits of “super savers”: people who contribute at least 15% of their pay to a 401(k) account.
The article highlighted a particular habit that 49% of super savers have in common: driving an older car.
Avoiding car loans has long been recognized as one of the habits likely to help you accumulate real wealth.
“The Millionaire Next Door: The Surprising Secrets of America’s Wealthy,” a best-selling book originally published in 1996, is perhaps most famous for emphasizing this phenomenon.
In the chapter “You Aren’t What You Drive,” the author pointed out that 23.5% of millionaires own a car from the current model year, while 55% own cars older than two years.
“The used vehicle-prone shopper group … contains the highest percentage of prodigious accumulators of wealth (those with a high net worth to income ratio),” the author concluded.
For many of us, vehicles are the second-largest purchase we’ll ever make (behind a home). It makes logical sense that being frugal with such an important cost center can make a huge difference in your finances.
But just how much of a difference? Is driving an old beater really going to turn you into a millionaire?
Table of Contents
- The Expensive Truth About Car Loans and Purchases in 2022
- Clark Howard’s Maximum Auto Loan Length Rule
- How Much Do Auto Loans Really Cost You?
The Expensive Truth About Car Loans and Purchases in 2022
I haven’t bought a car since 2013. So some of the car-related stats from this year are eye-catching to me.
To wit:
- The average car loan in the United States in 2022 is 70 months.
- The most common car loan term is 72 months.
- The second-most common term length is 84 months.
- In the first quarter of 2022, 73% of new auto loans were for terms longer than 60 months.
- The average car loan for new vehicles in the second quarter of 2022 was $40,602.
- The average used car price was $28,219 in July. The average new car price: $48,182.
Vehicle prices are finally starting to moderate, after a confluence of factors related to COVID-19 created a massive supply deficit just as demand got white-hot, rocketing prices well above MSRP.
If 72 or 84-month loans don’t seem especially long to you, consider that the average ownership cycle of a vehicle is 8.4 years. It’s presumably less than that for used vehicles.
New vehicles also depreciate in value as soon as you drive them off the lot.
So loans that last seven or eight years can leave you upside down (that means the car is worth less than what you owe on it). It can also ensure that you always have a car payment rather than experiencing years where you own your vehicle free and clear.
Finally, the longer it takes for you to pay off your loan, the less your car is likely to be worth, as your vehicle contends with more miles, more wear and more outdated technology and style.
Clark Howard’s Maximum Auto Loan Length Rule
Money expert Clark Howard isn’t a big proponent of taking on lengthy terms for loans. Clark has a strict rule for auto loans in terms of a maximum length.
“The longest auto loan you should ever take out is 42 months,” Clark says. “If you can’t afford the payment on a 42-month loan, then you should buy a cheaper car.”
Clark also says to be especially careful about financing anything when the prices are inflated or when you’re already straining to pay your monthly bills.
One thing you can do to keep your monthly payment reasonable, even in the short term, is to make a sizeable down payment when you buy your vehicle. The more money you pay upfront, the less you’ll pay in interest.
It will also give you a better chance to owe less than your car is worth — even if it’s a new car that you drive off the lot (and it immediately goes down in value).
How Much Do Auto Loans Really Cost You?
With vehicle prices at higher than normal levels, inflation at its highest point in decades and interest rates rising due to large hikes by the Federal Reserve, vehicle purchases are squeezing your wallet as hard as ever.
Monthly car payments of $1,000 have become commonplace.
The average interest rate on an auto loan was 4.33% for a new car and 8.62% for a used car in the second quarter of 2022. Those numbers should continue to rise as long as the Fed continues raising interest rates.
But just how much are you costing yourself by falling in line with the averages when it comes to auto loans and prices?
Simply avoiding auto loan payments and investing the money may not make you a millionaire. But the opportunity cost of these types of loans, year in and year out, is substantial.
Checking the Math: Opportunity Cost For a New Car Loan
Let’s take a look at auto loans for new vehicles. Remember, in the second quarter of this year, the average new car loan was $40,602. So let’s assume a $40,000 loan at 5% interest.
Based on different loan term lengths, let’s look at how much you’d pay in interest. If instead, you invested that same amount of money for 20 years at an annual ROI of 7%, how much money would you make?
| Loan Term | $40,000 at 5% | Total Cost | Total Interest Paid | 7% ROI/20 Years |
|---|---|---|---|---|
| 48 Months | $921/month | $44,208 | $4,208 | $16,284 |
| 60 Months | $755/month | $45,300 | $5,300 | $20,509 |
| 72 Months | $644/month | $46,368 | $6,368 | $24,642 |
| 84 Months | $565/month | $47,460 | $7,460 | $28,868 |
If you took all the interest you’d pay on a 48-month loan — the maximum amount Clark recommends — and invested it for 20 years, you may expect to make $16,284.
However, if you took on an 84-month loan, the interest you pay could represent an opportunity cost of $28,868.
Imagine if your household is paying for car loans on multiple vehicles. And if that cycle repeats itself every eight years, constantly keeping you on the hook for monthly loan payments over decades.
Suddenly the money you’re paying in auto loan interest can add up to hundreds of dollars.
Checking the Math: Opportunity Cost For a Used Car Loan
Now let’s look at a used car loan of $20,000 at 9% interest.
| Loan Term | $20,000 at 9% | Total Cost | Total Interest Paid | 7% ROI/20 Years |
|---|---|---|---|---|
| 48 Months | $498/month | $23,904 | $3,904 | $15,107 |
| 60 Months | $415/month | $24,900 | $4,900 | $18,961 |
| 72 Months | $361/month | $25,992 | $5,992 | $23,187 |
| 84 Months | $322/month | $27,048 | $7,048 | $27,274 |
As you can see, investing the money for 20 years at 7% instead of paying it to a bank to cover loan interest leaves you with a similar amount of money. That’s $15,107 on a 48-month loan and $27,274 on an 84-month loan.
Even if you go through a credit union and secure a loan rate that’s more akin to what we used in our first example, you’re still shelling out a good amount of money in principal and interest vs. owning your car outright.
Final Thoughts
Choosing to drive an older car that you own outright isn’t going to make you a millionaire on its own.
But if you’re willing to invest the money you’d otherwise spend on a car payment, the long-term financial benefit could be huge. The more time that money has to compound over the years and decades, the better.
And the fewer years you’re making expensive vehicle loan payments, the more likely you’ll be to accrue wealth.
