Your car can be a major part of your life. It gets you from Point A to Point B, but for some, it's so much more. It's a reflection of your lifestyle - of you! If you have a family, you have to consider a vehicle with room for car seats, sports equipment, etc. If you need to haul heavy or large items, maybe you need a truck. Or, let's be honest - perhaps you just want to make an impression on others and want that premium luxury car. Whatever your reasons, there are two universal truths about cars: they lose value over time and are major lifetime expenses! Yes, there are the incredibly rare cases of a vintage sports car appreciating in value, but chances are your 2010 Ford Focus is not going to be a hot item in 2050. So how do you find the right car that meets both your daily needs and personal finances? This is such a big expense in your life, I thought it best to make this topic a three-parter. This week, I'll focus on that devious trap of financing your vehicle.
I could have paid a mortgage on a modest home with loan I have on this car!
What Will It Take To Get You In This Car Today?
Car dealerships are so nice! Not only will they sell you a car, you don't have to pay for it right away. You can just agree to small monthly payment and you can drive off in that $48,000 truck without worries. They checked your credit, and you're good to go. Just sign on the dotted line.
Not so fast, smart guy. While you got the shiny pick-up you've always wanted, you're now paying for this bundle of joy over 72 months (aka 6 years!), at a healthy interest rate of 8%. So let's say at year 4 you want to upgrade to the latest model with the cooled cup holders? Sure, they can just take your trade-in and roll in the remainder of the loan into the new $55,000 loan, again spread over 6 years. All of the sudden, you're paying over $1,000/month over six years! That's a mortgage payment in many places.
If you don't believe me, here's a real example. You could finance a $65,000 2020 Audi A6 with no money down with average credit. Let's say you make $75,000/year. You'd be saddled with a $1,202 car payment for six years. Assuming a 25% tax rate, your take-home pay would be about $4,690. That means about 26% of your money is going to transportation? This doesn't even include the general maintenance of a car (more expensive cars tend to cost more for upkeep).
You could finance this car, or just light $40 on fire every day, up to you.
While this example may sound ridiculous, it's sadly true. As I wrote last week about The Starbucks Mentality, many get caught up in thinking they can afford luxury items because they see friends, family, co-workers, or neighbors enjoying them. But are these people truly able to afford such nice things, or are they also being sucked into lifestyle choices beyond their means? Don't get trapped in the vicious debt cycle in order to "keep up with the Joneses."
Who steps out of a car with a facial expression like that?
Buy Outright!
If you can't afford it today, what makes you think you can afford it in the future? Dealerships will always offer financing for a reason - they make money on it! Either they will contract with a financier or do some themselves. I ran some numbers using some basic assumptions. Say you wanted to buy a car for $20,000. Using a third-party financing model, I found a monthly payment of $370 over 72 months for "average credit". Sounds pretty reasonable, right? Well, if you break that down, you're paying over $26,000 over the life of the loan! Additionally, using Net Present Value (NPV) to figure out cost in today's dollars, you're paying about $21,100 for that same car just by financing it. Keep in mind, interest rates in the U.S. are very low at this time, and actual costs would only go up from here.
What if you don't have $20,000 laying around for a car? Ask yourself these questions before financing:
Do you really need another car?
So many people buy a different car simply because they just want something different. No practical reason. Can your purchase wait a few months (or even years) to save up to buy outright?
Is there a less expensive alternative you can buy?
Do you need a 2020 car when the 2017 has most of the same features? Can you forgo the premium package and settle for the standard model?
Are there financing alternatives?
Don't simply accept the terms and rate of the dealership financing. Check local banks or credit unions for their financing options. While I would never suggest pulling money out of an emergency fund or retirement savings for a car, always weigh the financial implications. If the best rate you can find is 12%, your existing car is totaled, and you have the money to pay outright in emergency savings, that makes sense. But in order to buy that $65,000 Audi A6 from the example above, you shouldn't take an early withdrawal penalty from your 401(k) to make this car happen.
Hopefully I've hammered home the importance of fiscally-responsible car-buying. Next week, I'll focus on finding the right car for you. Until then, keep driving that hail-damaged 2013 Hyundai Sonata into the ground as long as it keeps running!
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