Debt and savings: they both snowball

A note at the back of the users manual for my financial calculator: “There are two processes that can take place in finance; amortization (systematic elimination of debt) and growth (systematic accumulation of wealth).”

That’s a brilliantly succinct statement, which boils down to this: because of the nature of compounding interest, getting in debt can snowball and make you poorer, while saving money can snowball and make you richer.

I was pondering this while mustering the resolve to spend a Sunday afternoon doing a bit of trouble shooting on my aging car.

It’s hot out there.

My tools are scattered and disorganized.

I’d rather goof off than slave away under the hood….oh, I’d sure like a new car.

So I did a quick analysis of the financial angle of buying a new car, and it runs like so….

If I was to buy a new car here, assume a cost of $22,000, which seems to be the average price. Assume that I financed it for four years at an interest rate of 11.5%. In this case, the car payments would come to $574 per month.

There would, as well, be additional insurance costs, but for the sake of simplicity we’ll ignore those. In fact, I’ll just assume that these costs are what I’d have to sink into an older car for repairs to keep the thing limping along.

Of course, if your car totally dies then you’ve got no choice but to get another one. But in most cases, I suspect that folks buying new cars aren’t doing so because their old ones won’t run anymore. They just want something new.

Turning back to this monthly payment of $574, let’s assume that I turn the tables on the deal and try to play the accumulation of wealth angle. Instead of buying the new car, I save $574 each month, earning, say, eight percent a year in my investment portfolio.

Here’s where things get interesting. At the end of four years, this $574 in monthly savings will have piled up to $32,342.

(For you finance geeks out there keeping score to keep me honest, I based the last calculation on a monthly compounding period, just as the amortization for the car loan would be amortized monthly. My next calculation is compounded yearly.)

Like the those television infomercials say, “but wait, there’s more.” And here’s the more: Let’s assume in four years that I take this $32,342 and just let it ride for 25 years as part of my retirement. It earns eight percent a year in an investment portfolio. In 25 years, I will have saved $221,497.

Cazart–that’s close to a quarter million dollars! Talk about a “systematic accumulation of wealth.”

I’ll point this out, though: The best investment I ever made was buying my car new (back in 1986). I’d rather buy a new car than a used one. But it’s wise to keep in mind the long term financial factors involved in the debt vs. savings decision. A new car can be necessity or a luxury. It’s useful to crunch some numbers when making these kinds of financial decisions.