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"A Tale of Two Trucks" | Determining the Payback

“A Tale of Two Trucks”

     Two enterprising young college grads landed great jobs, having studied hard and interviewed well.   Both “Larry” and “Beth” started their careers with handsome salaries and bright futures.

      These two bright young people, since they started driving at age 16, had wanted to own a new Toyota Four Wheel Drive Pickup, but had fought off that urge in favor of squeezing all the education possible out of their dollars.  Each of them drove, out of necessity and thrift, ancient “beaters” which were neither sporty nor swift.

     After accepting his new position, Larry drove past the car dealership…. Well, not quite past.  He drove out in a shiny new Toyota 4X4, after negotiating a $2,000 trade-in on “The Beast” and a 12% loan on the $19,975 balance.

     Accelerating onto the freeway, he felt great!  The $526.02 monthly payment would be easy with his new paycheck, and his truck would be paid for in four short years!

     Beth avoided close contact with car lots for quite a while after graduation…. She wanted to take her Dad’s advice and buy a rig with cash, later.  Dad called it “deferred gratification”.

     Larry soon found out that a new rig means higher insurance bills….. the $60 per month increase in his insurance bill was exactly what it cost Beth to repair her “hunk of junk” over the next four years.

     Beth saved $526.02 out of her first paycheck and started an investment account, regularly adding $526.02 a month.  However, the fund did not do very well…. Over the first 4 years she invested, it averaged just 8% a year.  That was enough to accumulate $28,206 by the time Larry paid off his Toyota.    At that point, her nearly-dead car (baling wire and duct tape can do only so much!) and $21,000 cash were enough to take home a new Toyota 4X4, leaving her with $7,206 in her investment account, to which she habitually added $526.02 a month.

     Meanwhile, across town, Larry’s truck, like all new and shiny things, wore out.  When the last payment was made,  Larry negotiated a deal for a new one…. After the trade, he owed just $19,975, which he financed over 4 years at 12% interest, for $526.02 a month.  He felt great…. A new rig, and the same payment!

      Beth’s first truck and Larry’s second one wore out simultaneously…. Not  technically worn out, but not new either.  Beth’s investment account had earned 12% a year this time, and the balance had grown  to $43,825; she traded in her old rig, added $19,975 in cash, and drove off in a new Toyota.  Larry’s loan was paid off, so he traded in the old, financed the $19,975 balance, and drove off in the new rig, with that same old $526.02 monthly payment. 

    Of course, we’re not telling the whole story… both Beth and Larry married, moved, switched jobs, and had children.  The only constant was that each traded the old Toyota for the new one every four years.  Larry paid his $526.02 to the bank every month, Beth paid hers to the investment account, which continued to earn 12% a year.

      36 years after graduation, Beth grew tired of writing those $526.02 checks….. so she had her investment account begin to pay $8,272 to her every month.  She figures that if the fund only earns 8% a year on average, she can pay herself that much every month…. Forever.  Her balance is $1,240,816.  She smiles as she thinks of Dad’s “deferred gratification”.

     Meanwhile, across town Larry makes note that his truck loan is now paid off.  He’s quite tired of paying $526.02 a month…. Maybe this time, he’ll keep driving the ‘ol truck for a couple more years…. call it “deferred graduation”.  Besides, at 58 years old, it’s time to think about saving for retirement.

Determining the Payback

      In an effort to persuade you to buy new stuff, sellers of such brag that it will “pay for itself” in short time.  Whether it’s a new, more efficient heater, a solar electricity generator, house insulation, a cellphone plan, or whatever, they show you how saving $50 monthly adds up to paying for a $5,000 expenditure in, by simple math, 100 months. 

      If you bite on that pitch, you’re going for much too simple bait.  This type of logic does not incorporate the “time value of money”, or what else you could’ve done with that $5,000. 

      The more accurate way to figure the payback is to assume that if you DIDN’T (shockingly) buy the new gadget but kept the old one, you could invest that $5,000 and use the investment’s returns  to pay the higher monthly cost without the savings. 

     Let’s go back and NOT buy the $5k thingamajig, but keep that $5k in a money market fund earning 4.5%, and from that account, pay the $50 per month in inefficiency.  The first month, you would earn $18.75 in interest, pay out the $50, and wind up with $4,968 left.  Play it out, and you will see that after 100 months, you still have $1,194 in the money market, and that your payback period is 125 months. 

      If you assume a higher rate of return, the payback gets longer.  In this case, if you can earn 8%, the payback is 163 months, or about 13.6 years.  The higher the assumed earnings and the larger the initial cost in relation to the savings, the longer the payback.  If you need to spend $7,500 in order to save $50 per month, you will NEVER achieve any payback if you sacrifice earning 8% per month. 

     If you need to BORROW the money to do this, it gets even worse.  Let’s assume that you borrow $5000, paying it back over 5 years, at 8% interest, with an amortizing loan.  The payment is $100.71 per month.  You save $50 per month, but for 5 years, you are out an EXTRA $50.71 per month.  Had you not borrowed, you could have put that $50.71 monthly into a 4.5% money market fund, building up a balance of $3,471 over 5 years.  This would be sufficient to pay that extra $50 in inefficiency for 7.3 more years.  So instead of a 5 year payback, in this case it takes 12.3 years to “pay for itself”.  And if you instead put that $50.71 per month you saved by not having the loan for the first 5 years into a mutual fund earning 8% per year, it takes 13.5 years to “pay for itself”.

     In recent years, I have seen people spend up to $100,000 on solar electrical generators.  With this large an expenditure, it’s crucial to accurately calculate payback times.  If you have a situation that requires this calculation, just email us and we will do this for you.

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