I warn you this is going to be another post with numbers ?. However, I like to use numbers because it helps demonstrate why my financial advice is solid. Here are my rules on car ownership:
1) The value of your car(s) and all motorized vehicles should be less than 50% of your gross income. This includes boats and motorcycles as well. It’s a good rule of thumb to use since motorized vehicles are depreciating assets. This means they always lose value especially in the first five years unlike a home which typically gains value, building equity. Plus the 50% rule of thumb gives you practical limitations on what you can truly afford.
2) Save up and pay cash for your car. Don’t get yourself trapped in years of car payments. Many people look at me like I’m crazy when I say this but guess what, it’s time to be an adult and plan accordingly. If you’re driving a 20 year old car and know it’s on its last wheel, start putting money aside as part of your monthly budget for your “car fund.”
3) Don’t buy a brand new car. You lose a ton of money as soon as you drive it off the lot (depreciation/loss of value). Ideally you should get a car at least a few years old as long as you can pay cash for it and stay under 50% of your gross income. If not, you need to get one even older. Here are average depreciation rates: 11% after driving it off the lot, 25% after one year, 46% after three years and 63% after five years. What this means is that your car will lose 63% of its value after five years. Of course these are averages and it really depends on the year, make and model. There are numerous car depreciation calculators online if you want to take a look at your car’s expected depreciation.
Emergency Plan: This is the ONLY time you should get a loan for a car. If your current car is dead, you don’t have money saved up and you need a car to get to your job, make sure you get an older car with a value less than 25% of your gross income. Plus you should shop around for the best interest rate. ABSOLUTELY DO NOT LEASE A CAR! This is a waste of money and you become a slave to the car dealership.
Now let’s talk about the nitty gritty. I’ve made car buying mistakes in the past. I’ve bought a brand new car and I’ve leased. I was in my early twenties so didn’t know any better even though I should have since I’ve always been a financial person. I was young and still in the stage of doing “stupid things” and apparently didn’t want to think my way through the transaction because my immaturity didn’t allow it. However, I’ve become wiser as I’ve gotten older.
Now I’m going to face reality and think my way through my “brand new” car transaction. I was so happy driving it home. It had 20 miles on the odometer and smelled “new car” fresh. This fancy new car was all mine. It wasn’t really that fancy but in my mind it was. I threw away approximately 11% of the purchase price immediately (depreciation). I can’t remember exactly how much this car cost me but let’s just say it was $35,000 which is also the average price of a new car nowadays. So that means the drive home cost me $3,850. Ugh! I now think about what I could have done with $3,850.
Now fast forward a year. The new car smell has worn off and I’m not as excited about my “not so new” car as when I first drove it off the lot. Plus I’ve thrown another 14% out the window. This is an additional $4,900 for a total of $8,750 (25% loss in value after one year). If I had bought a car that was at least one year old and invested that $8,750 instead, twenty years later (now) I would have over $35,000, using a conservative 7% interest rate.
Now let’s think about the car payments. Assuming the $35,000 loan cost me 2.98% with a 60 month term, the payments would be $629 per month. Again, I can’t remember my interest rate but we’ll go with average numbers from the present day. That means over five years I spent $37,740. Why couldn’t I have saved $629 per month for a year and bought a used car for $7,548? After all, I was committing to the fact that I could afford $629 per month. Or maybe I could have held out for something even nicer and saved for a couple years to pay cash for a $15,000 car. Why did I pay the bank $2,740 in interest and take the hit on depreciation which would now be worth 35K?
Let’s say I went with scenario two instead where I saved for a couple years and paid $15,000 cash for a used car, didn’t pay the bank a dime and depreciation on that used car is much lower. Then I invest $629 per month for the next three years. Again, I committed to the fact that I could spend $629 per month for five years. To be consistent, assuming a conservative 7% interest rate, by the end of the three years I would have contributed $22,644 and earned $2600. If I hadn’t contributed another dime but left the money alone ($25,244), 15 years later (now) I would have $71,919. I would have over $71K for making a different decision for one car! Was that brand new car worth it? I think not!
Imagine if you’re one of those people who always have a $400 car lease for most of your adult life. If you had invested this money starting at age 25 through age 65, you would have $1,056,050 (using a 7% interest rate). This means you invested $192,000 and earned interest of $864K instead of making a monthly car payment. I would much rather earn interest and be a millionaire than thow my money away.
By the way, once you hit millionaire status, go ahead and buy a new car! When you’re a millionaire, buying a brand new car is not as big of a deal because it’s a small portion of your net worth. Plus you’re using money that made money (compound interest), not money you worked hard to make, if that makes sense. Of course, be smart about it and pay cash. Don’t pay the bank a dime! If you’re not sure what being a millionaire means, read my post: You CAN become a millionaire on an average income.
Think about your current motorized vehicle situation. If all your motorized vehicles are valued at more than 50% of your income, you should consider selling some to get under that number. You can then use that money to pay off other debt or invest in an index mutual fund.
You should also consider your future car ownership plans. Do you have a car savings fund and are you saving enough to pay cash for your next car? I have found the biggest way to build wealth is to have a plan for your money rather than having your money control you.