A “financial project” is an item whose cost is large enough that advance planning is required to pay for it. The baseline for what qualifies as a financial project is subjective. But if you have to save, borrow, liquidate assets, or in some other way plan to pay for it, that’s a financial project.
For most Americans, their biggest financial project, both in duration and dollars, is funding their retirement. But prior to retirement, many Americans will also encounter other smaller, shorter term financial projects that also need funding. And the choices they make to address these smaller projects can significantly impact the outcome of their biggest one.
Consider two common “mid-size” financial projects: the purchase of a new car and paying for a wedding. Each has a price tag of around $30,000, and a range of funding options.
A New Car
According to an April 1, 2016, Kelley Blue Book update, the average price of a new car in March 2016 was $33,666. (The average purchase price of pickups is around $45,000, representing the greatest percentage of new-car sales.) And cars wear out; they aren’t one-time financial projects. Studies indicate most American households will own between 6 and 8 cars in their lifetime.
How do most new car buyers pay for their transaction? In April 2015, Experian Automotive reported that approximately 15% of new car buyers paid cash. The rest opted to borrow, for increasingly longer periods. The above-mentioned Kelley press release found an increase in 72- and 84-month loans, with the average for all loans at 67 months.
The Wedding Report’s annual survey found the average wedding in 2015 cost $26,601, not including the cost of the honeymoon. Wedding costs varied by geographic regions of the US, with the highest averages in the Northeast ($32,952) and West ($29,425), and the lowest in the Midwest ($24,614). When calculating averages, ultra-high-cost weddings can skew the numbers, but the Wedding Report found 16 % of all weddings were in excess of $30,000.
As a one-day event, weddings don’t have monthly financing options comparable to automobiles. Besides the higher-interest options of credit cards or unsecured personal loans, the merits of using home equity versus retirement savings are the options that generate a lot of discussion. A 2014 TIAA-CREF report found that 15% of 401(k) loans were used for weddings and vacations.
The Impact of a $30,000 Project on Retirement
When money is diverted from your retirement (either as lump sum or reduced contributions) to pay for some other financial project, the cost isn’t just $30,000. There are lost opportunity costs in the liquidation of long-term assets; what’s spent today is not only gone, but so are the future earnings. There’s also a diversion of future savings to debt service, which for many households means a decrease in monthly saving. (Example: If previous savings allocations were $500/mo., the new allocation is $350 to saving, $150 to loan repayments. The TIAA-CREF survey said more than half of 401(k) borrowers decrease their future retirement contributions to repay their loans.) If a 401(k) is the source of borrowed funds, repayments are made with after-tax dollars – which will be taxed again when you take withdrawals at retirement.
If you’re 50 when your daughter gets married, and you pay the $30,000 tab by liquidating an investment, there’s likely 20 years of retirement opportunity cost attached to that decision. Compounded at a hypothetical 5% for 20 years, that’s almost $80,000; at 8%, the number is $140,000.
The financial consequences of purchasing a new car are harder to calculate. Transportation expenses are part of a household’s cost of living, whether buying or leasing, and so are the ancillary expenses of insurance and maintenance. So you really can’t say that a monthly car payment is money that isn’t going to retirement. But you can consider the long-term impact of financing. A $30,000 auto loan at 5% interest amortized over 6 years (72 payments), results in a monthly payment of $483, which includes $4,776 in interest. At 5%, the opportunity cost on the interest is $5,854 after six years. If you financed the car at 35, by age 70 the calculated opportunity cost on the interest from that one loan is $24,000. Opportunity costs for successive loans will be less because the time to retirement is shorter, but even with conservative opportunity cost assumptions, the cumulative effect of six to eight auto loans over a lifetime could easily exceed $100,000.
Throw in another $30,000 project during your working lifetime (like a small home improvement), and it’s plausible that three mid-size projects have the potential to reduce your retirement accumulation by $300,000. That’s no small number.
Obviously, the preferred approach to these mid-size financial projects is to save for them. For some, this means their saving focus has to expand beyond retirement (the big project). While some financial commentary has a “don’t sweat the small stuff” approach – i.e., “just maximize allocations to your biggest financial project, and all of the others will somehow work out” – other projects, like cars and weddings, are not only likely, but costly. When the only project people intentionally save for is retirement, other intermediate projects will inevitably disrupt the big one.
Along with saving strategies and financial products, many financial professionals have programs to help assess the “true costs” of your mid-size financial products. When reviewing the status of your bigger financial projects, it might be worthwhile to include a cost analysis of your mid-size ones as well.