The worst investment a teenager can make

One purchase decision while you're young will affect your future wealth more than almost any other. 

If you're a teenager or in your early 20's, few things are as toxic to your future wealth as that new-car smell. Tempting as it is, buying a car is an expensive decision – and staying patient for just a few extra years will pay off big time down the track.

Let's do the maths using a real-world example. One of the most popular cars for young people is the Volkswagen Polo, with around 15% of sales going to customers aged under 25. A new Polo will set you back around $20,000 for the mid-range model.

The NRMA estimates that new cars lose 30% of their value in the first three years, and a 10% depreciation rate is typical thereafter. The average length of ownership for a new car is seven years, so, if you hold onto your Polo for that long, it will roughly halve in value to $10,000.

Depreciation is an expense every bit as real as the cost of petrol. In fact, it's the worst kind of expense, because you're handing over cash upfront. That $10,000 of lost value is the hidden cost of car ownership, but it's just the beginning.

Insuring a Polo as a teenager or 20-something will probably set you back at least $1,300 a year, and petrol will run at around $2,000 a year assuming you do 20,000km, which is usual. Throw in depreciation, then some spare change for maintenance and parking meters, and it's easy to crack $5,000 a year in car expenses.

Debt trap

You may be tempted to borrow money to buy your first car, but the only thing this will do is super-charge your losses. Paying interest to buy a depreciating asset is one of the worst financial mistakes you can make.

Using Westpac's car loan calculator, a $20,000 loan at a fixed rate of 8.5% over seven years will set you back around $317 a month. That doesn't seem too bad until you read the fine print: over the life of the loan, your total cost will come to almost $27,000. That is, after seven years your $20,000 Polo will only be worth $10,000 – but you've handed over $27,000 to own it.

It's usually better to pay for your car – new or used – in cash. At least then you're swapping one depreciating asset for another, and it will save you a fortune in interest. At the very least, check if you qualify for financing through the car dealership as it's usually cheaper than through the big banks.

If you do need financing to buy your car, try to pay it off as fast as possible. Making extra repayments on a car loan that charges, say, 8.5% means you're effectively getting an 8.5% return on your money. It's also tax free, so if your marginal income tax rate is 20%, that 8.5% saving is the same as an 11% return from stocks or other assets.

The difference

So what difference does owning a car really make to your long-term wealth?

Let's assume you choose to avoid a loan and that extra $1,000 a year in interest payments. The annual cost of owning a Polo, then, might come to around $4,000 excluding depreciation, which we'll add later.

However, if you don't buy a car, you will still need to get around and so have to pay for public transport. In Sydney, the weekly cap for an Opal Card is $61.60, but there's a 50% discount for students. If you're a teenager or in your early 20's, you're probably in that category and so hitting the weekly cap of $30.80, or $1,600 a year. After accounting for this ‘saving', you would still be outlaying an extra $2,400 or so a year to own a car.

Now for the magic of compounding. Over the past 30 years, the Australian sharemarket has returned 9.6% a year on average.

With a return of 9.6%, how much do you suppose that $2,400 a year would be worth down the road if you choose to save and invest, rather than own a car? Over seven years, it would come to around $27,000 and over ten it would come to $43,500.

This, however, is only considering the savings you would make on running costs. The initial $20,000 to buy the car needs to be factored in too. Using the same return assumption, $20,000 invested at 9.6% for seven years would be worth $38,000. Had you opted for the Polo, you would have that $10,000 machine instead – a difference of $28,000.

Adding it all together, you would be $55,000 richer after seven years of choosing to use public transport instead of buying the car.

Now let's assume you take your $55,000 honeypot and buy a $20,000 car when you're, say, 26 years old, rather than at 19. The extra $35,000 you have left over would grow to $1.2m by the time you retire, assuming a 9.6% return. Even after deducting a few percent for inflation, it's reasonable to assume you would be around $425,000 richer in today's dollars – all from that one decision to hold off buying a car until your mid-20s.

As we explained in So your kids want to be millionaires? Show them how with one chart, putting money aside while you're young makes a huge difference to your future wealth. Owning a car is one of the biggest cash-burners around. If you stay patient and invest the savings, one day you could be driving a far better car than you ever imagined.

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