A recent Automotive News article reported that while Millennials now represent the fastest-growing segment of new car buyers, their buying behaviors might not make the most financial sense—a fact that could have significant implications both for the auto industry and for the younger generation’s broader financial health.
As author Hannah Lutz writes:
Millennials… will represent 40 percent of the new-vehicle market by 2020, Automotive News reported this week.
Unlike baby boomers, millennials calculate affordability by monthly payment rather than total purchase price, said Jeff Schuster, senior vice president of forecasting with LMC Automotive…
Young consumers are accustomed to a payment, subscription-based culture. It fits in with the rest of their purchasing habits.
AutoGravity, a financial technology company whose leasing and financing mobile app and web platform enables consumers to arrange their transaction with a dealership and lender, is working on a solution that would enable customers to search by monthly payment and vehicle type. Customers could search for an SUV at a maximum payment of $300 per month, for example.
The “subscription-based culture” mentioned by the author is another name for the growing “subscription economy,” which has begun to rewrite business models in industries, from entertainment to personal care to cell phones and even fashion.
From a consumer perspective, the convenience of the subscription model is incredibly appealing, and it often even makes financial sense, opening up an opportunity for discounts, while still retaining purchase flexibility. It also makes monthly budgeting a fairly simple task, since more expenses are converted from irregular and variable costs to predictable, fixed costs.
For a generation that places a premium on flexibility and freedom of choice—often out of necessity, due to uncertainty of future income potential—the subscription concept works well. Perhaps not surprisingly, Millennials are, on the whole, quite good at day-to-day budgeting.
Unfortunately, the monthly payment-based approach that Millennials seemingly use to balance their budgets happens to be a particularly terrible way to approach a major, debt-based purchase, like that of a car (or house). After all, the best way to minimize a monthly payment for a purchase is to extend the loan term, even if extending the term means paying a higher interest rate and incurring a significantly higher total cost of ownership.
Consider the following chart, which shows the monthly payments for a $20,000 car at various term lengths and interest rates:
If a car buyer walked into a dealer only wanting to spend a maximum of $375 per month for the car in question, that buyer would then theoretically be indifferent between a 60-month loan at 5% interest, a 66-month loan at 8% interest, and a 72-month loan at 10% interest.
Obviously, the differences between those loans are quite significant, even though the payments are identical—the total interest cost over the course of the loan is just $2,645 for the 60-month loan, but a full $6,677 for the 72-month loan. Sure, it may seem far-fetched that a car buyer wouldn’t be able to see that difference right off the bat, but industry trends suggest otherwise. Indeed, car loan terms have been steadily increasing as Millennials have entered the market, even as interest rates have generally been declining.
While the longer loan terms might allow payments to fit better into monthly budgets, it’s a near-certainty that the total cost of ownership has increased along with the loan terms (it’s also likely that the longer loan terms are being used as a tool to “afford” more expensive cars, which is its own issue).
As an ironic side effect, the longer loan term might actually be decreasing the very flexibility that most younger car buyers so desperately crave—the longer the loan term, the longer it takes a buyer to get “above water” on the car purchase, where the remaining loan balance is less than the depreciated value of the car. Longer required holding periods means less of an ability to trade in or trade up to a better, newer car, a dynamic that many first-time car buyers might not readily appreciate.
Unfortunately for the rest of us, this myopic focus on periodic payments isn’t limited to younger folks, nor is it limited to car purchase decisions. On the contrary, the mentality has bled into portfolio management decisions, to the detriment of many investors.
Consider a Wall Street Journal article from last week, relating the case of a retired dentist on Long Island:
Stocks are hitting record after record, the Dow Jones Industrial Average tripling since it bottomed out during the financial crisis exactly eight years ago.
For many retirees who’ve been riding that wave, these are risky and confusing times.
Take Steve Stein, a retired dentist here on New York’s Long Island. At 82, Dr. Stein said his nest egg of roughly half a million dollars is 95% invested in stocks. As a rule of thumb, financial planners suggest subtracting an investor’s age from 100 to determine what proportion of savings to allocate to stocks.
“My dad used to put his money in CDs, getting 15%,” said Dr. Stein, whose father, a dental technician, encouraged him to become a dentist as a way to build a stable, successful life. “If interest rates were high, I would’ve invested in fixed income,” he said…
Nearly all of Dr. Stein’s savings is in exchange-traded funds, a type of stock-tracking product he mostly uses to invest in health-care companies. He doesn’t hold bonds, which he views as providing too little yield. Instead, he has scooped up biotechnology stocks, which he has watched climb in the past decade.
He said he checks his portfolio’s performance every day and worries about big swings. He has seen some. One of his holdings, the SPDR S&P Biotech ETF, fell 16% last year. It is up 19% so far this year. The only way to realize these gains, however, is by selling pieces of the portfolio, something Dr. Stein is wary to do for fear of mistiming the market by selling stocks near their lows or buying near their highs.
If Dr. Stein’s “if interest rates were high” justification sounds familiar, it is. It’s a variation on the same single-factor focus on monthly payments that has led car buyers to consistently extend the terms of their car loans, to the detriment of their long-term financial health. “The rate isn’t high enough” on bonds, so more risk must be accepted. But as I’ve written about here multiple times recently, judging an asset class—or assessing an interest rate “environment”—without recognizing the differences between various types of investments is missing the point.
A monthly payment alone isn’t enough information to determine whether a car purchase is a good decision, nor is an interest rate alone enough information to determine whether an investment is a good decision. Is 5% a good interest rate (or yield) for an investment? It depends, of course, on the quality of the issuer, the term (or maturity) of the investment, and the broader macroeconomic environment.
The 15% interest rate that Dr. Stein wistfully describes sounds wonderful on the surface, until you recognize that the last time CDs paid that sort of a rate (they would have done so only briefly, likely between 1980 and 1982, in the Volcker era), the annual inflation rate was also between 13% and 14%, and the CDs were thus yielding a “real” (inflation-adjusted) interest rate that’s roughly in line with today’s rates.
While Dr. Stein’s apparent decision to invest in biotech ETFs instead of bonds is certainly an unconventional head-scratcher (the leading biotech ETF pays only a minimal dividend, so it’s not exactly a typical bond surrogate), the more traditional alternatives also come with significant drawbacks. Some investors have responded to the low-rate environment by extending maturity, compromising on quality, or investing in dividend-paying stocks instead. In all cases, flexibility to respond to a changing interest rate environment is sacrificed in some form or fashion.
As always in financial markets (and in life), there’s no such thing as a free lunch. When deciding among investments, no single factor is ever sufficient to embrace (or shun) an investment or asset class. Yes, the rate is important, but so are a number of other questions. What is the broader inflation rate? What is the creditworthiness of the underlying lender (or company)? What is likely to happen to my investment in a recession? Or in a rising (or declining) interest rate environment? How long is my money “locked up” for? Are there any fees that might eat into my stated yield or return?
With investments as with car purchases, considering all of the relevant characteristics of our various investment options, as well as the totality of our own financial picture, is essential. Eschewing bonds simply because rates are low is neither right nor wrong in any broad sense; indeed, it could be either. It’s just that making any financial decision based only on one factor is destined to be a poor long-term approach.