Cars are incredible inventions. They allow you to transport yourself hundreds of miles, whenever you want, in a relatively short time period. Cars allow you to arrive at your desk job without any sweat or dirt on your face. They also allow you to take amazing road trips and might even act as a camper on a rainy night.
Cars are a Depreciating Asset
However, don’t forget that cars are a luxury item. You are not entitled to a car and certainly not entitled to an expensive car. Moreover, your car is a consumption item. It is not an investment. It will lose value quickly. Therefore, if you are striving for financial freedom, you want to keep your car costs in a reasonable range.
Buy Your Car With Cash
The best way to make sure you don’t buy more car than you can afford is to buy your car with cash. If you have the money, you can buy the car. If you don’t have the money, then you can’t buy the car.
Americans are Drowning in Car Debt
Many Americans do not use this strategy. Over 100 million Americans have a car loan. That’s over 40% of the adult population in the United States. The average auto loan is around $30,000 and the average car payment is over $500. If you take that average monthly car payment of $500, and invest it instead at 5% real return from age 20 to age 65, you would have over $1.3 million dollars. Hope you like your car more than a comfortable retirement!
How To Buy Your Car with Cash
If you’re reading this in your teens or 20s and haven’t yet bought a car, I recommend that you work and save up enough to buy a starter car, perhaps around $2500. An older Toyota Corolla or Honda Accord should fit the bill. If you are wondering how it is possible to get around without a car, remember that you are young and capable. You can walk, ride a bike, or take the bus. It’s only temporary.
As you start to make more money, you can save up cash for a newer and better car. For example, once you have saved up $8,000, you can sell your old car (maybe it’s only worth $2,000 now), and use the proceeds to buy a $10,000 used car.
Don’t Buy Too Much Car
You can continue in this fashion, eventually working up to buying a new car with cash, but remember that a car is a consumption item and you are much more likely to become financially independent if you drive a modest car. According to Thomas Stanley’s The Millionaire Next Door, approximately 1/3 of millionaires still buy used cars. They became millionaires by being frugal, and to maintain that status, they need to maintain some degree of frugality.
In general, I recommend that you keep the worth of your car, as a percentage of your net worth, as low as possible, preferably 10% or lower. Obviously this will be challenging when you are starting out. If you have a negative net worth, then maybe you shouldn’t have a car at all. If your net worth is around zero, then buy the least expensive reliable car that will get you around. That $2,500 car above is reasonable.
As your net worth approaches $100,000, feel free to move up to around a $10,000 car. Once you hit a million, a $25,000 new car would not at all be unreasonable. But remember, as you’re moving up in car, you’re paying cash each time. Also, try not to get in the habit of perpetually upgrading to a different new car every few years. Most of the depreciation in a new car occurs in the first few years. So even if you are paying cash, it is most financially advantageous to keep your car for greater than 10 years before purchasing a new car.
What If You Already Have a Car Payment?
The scheme above works if you’re young and haven’t bought a car yet. But what if you already have a car payment? If you have no other debt and can pay off your car within a year or so, then feel free to keep the car. If you have other debt such as credit card debt, then I recommend you sell your car and buy that modest $2,500 or $5,000 used car with cash. Pay off all your debt and then save up some cash if you want a nicer car.
Did I Follow This Advice?
Unfortunately, I did not follow this advice. I claim ignorance and naiveté. After all, I didn’t really start to learn about personal finance until around 2012. The only thing I did right was delay car ownership. For the first 22 years of my life, I didn’t own a car at all. I got around by biking, walking, and taking the bus.
When I graduated with my engineering degree in 2004, I thought I deserved a new car, so I took out a $24,000 loan on a new 2004 Subaru Impreza WRX. The interest rate was low, something like 2%, but that didn’t matter. The point is that I didn’t have the money to be buying that kind of car. After all, I had around $40,000 in student loan debt!
How I Eventually Paid Off My Car Debt
I worked for a year between undergrad and medical school and made around $40,000 but I used this to pay off a portion of my undergrad debt rather than my car loan. I carried my car loan through medical school, all the while accumulating more student loan debt. When I graduated medical school, I again thought I deserved a new, better car, so in 2011 I sold my 2004 Subaru WRX for $8,000 and took out another $18,000 loan on a new 2012 Subaru WRX. In medical residency, while making around $50,000 per year, I paid off this car loan in around two years.
In 2014, I drove the 2012 Subaru WRX up to Alaska to start my first job out of residency and realized that sports cars are not practical in Alaska. So I sold my 2012 Subaru WRX for around $24,000 (nice used cars go for top dollar in AK), and purchased a 2015 Subaru Forester with cash. I was $400,000 in debt at that time, so even though I didn’t have a car payment, it was crazy to have a nice new car with that amount of debt! Thankfully, I have since annihilated the debt, but you could easily argue that I should have sold the 2012 WRX and instead bought a $2,500 used car and put the remaining $21,500 towards my debt.
My Wife Did Much Better
My wife was much smarter about her car purchases. When she was 16 years old, while working at a garden nursery, she paid cash for a late 1980s Toyota Corolla. She sold this during her first year of college while working as a waitress and paid $4,000 cash for a 1993 Toyota Camry LE. The Camry eventually died and in 2013, while working as a teacher, she paid $7,000 cash for a 2003 Subaru Outback sport. Well done! I married up for sure. Currently, we have no car payments and no debt and plan to keep it that way.
Summary
Remember that cars are a luxury item and a depreciating asset. Always pay cash for your cars and make sure not to have too much of your net worth tied up in your car. That seemingly innocuous $500 car payment could mean a $1 million difference in your freedom fund.
I definitely agree that depreciating assets will take a chunk out of your current and future net worth. I think most people will end up spending too much money in this category at least one point in their life and end up regretting it. I know I definitely did.
I will say this though about the 10% rule you mentioned. If someone who has a million-dollar net worth wants to buy a $50,000 car I would probably tell him to go right ahead if cars are their passion and it fits in their budget.
It’s nice to know that we both married up. My significant other is still driving around a car that is probably worth about $2,000 at this point.
I agree it’s not a linear relationship with the 10% net worth rule. Someone with a net worth of $10,000 will probably need some sort of car, and even a modest $2,500 car would be 25% of their net worth. At the other end of the spectrum, someone with a $2 million net worth would not necessarily be wise to purchase a $200,000 car (10% of their net worth). The point is simply to minimize the proportion of your net worth devoted to depreciating assets like cars. I think <10% is a good ballpark. A $50,000 car when you have a net worth of $1 million (5% of your net worth) is not completely unreasonable.
So we should really be buying used cars down in the states and shipping them to Alaska!
Solid, practical advice sir!
It costs around $2,000 to $3,000 to ship a car up to Alaska, so you probably won’t come out ahead. Since I drove it up there, it “only” cost me around $500 in gas. I was amazed that I essentially sold my car for what I bought it for 2 years earlier.
How long did your wife’s car last before that 4k cost was worth 0 because it died?
She now has a 14 year old outback she paid 7k for which has an engine known for head gasket issues. She bought that 4 years ago.
But your new 2015 forester will be reliable for a lot longer.
And you only lost 2k in depreciation on your 2012 Wrx after 2 years, that’s pretty good.
Not sure how you got killed so bad on your 04 though. Unless you put a ton of miles on it?
What happens if your 15 year old used car with 175k miles you bought for 2500 breaks down on the way to work? You miss a shift? Do you get fired? Maybe. Is it worth it? You lose that income too. Could be not much (residency) could be a lot (attending).
There is a lot more to this than you make it out to be.
Thank you for your comments. As with everything, there are intricacies and complicating factors and you certainly bring out a few of them.
In response to your questions:
1. The $4,000 1993 Toyota Camry lasted nearly a decade before it died. Pretty good cost per year!
2. I believe I had around 120,000 miles on the 2004 WRX when I sold it in 2012. That was a fair price for the age and mileage. I sold it to Carmax and I probably could have got $10,000 if I wanted to go through the hassle of finding a private buyer.
To address a few of your reliability concerns, it is possible to find a reasonably reliable $5,000 used car. I do appreciate the greater reliability of a newer car, but even those can break down. If your car does break down, there’s always Uber or Lyft. $20 will get you to work so you can avoid the lost income and save your job. You can also rent a car for a week, take the bus, or bike to work temporarily. While a break-down is certainly an inconvenience, there are plenty of options to deal with this hopefully rare occurrence.
Yeeeeeesssss! And when you buy your car with cash, don’t keep upgrading cars every two years, either. Buy a reliable car with cash and drive that sucker until the wheels fall off. 🙂
Exactly. That’s what I plan to do with my 2015 Forester. I just dropped $500 on a 30,000 mile service. I’m hoping this will help it last at least 10 years.
While I agree on the maths, the one thing that freaks me out about older/cheaper cars is the safety aspect.
Now this is going to be very dependent on where you live, but where I live road traffic accidents are common, and nasty (result of non-enforcement of road laws + high percentage of unroadworthy vehicles + poor road maintenence).
I bought my previous car cash, and I got an awesome price on it, but when it was stolen and I had to replace it I chose to finance. Largely because I couldn’t find anything similar for what the insurance paid out but also because I was doing a stint in trauma A&E at the time and seeing badly injured MVA patients every day. Kind of brought it home to me, so I got the safest car I could afford (also at a good price for what it is, although financed at a rate that would make most developed economy folks cry).
That is a reasonable concern. According to a National Highway Traffic Safety Administration study, the older a car is, the more likely it’s driver will die in a crash. https://www.consumerreports.org/cro/news/2013/09/study-measures-crash-risk-for-clunkers/index.htm
There is probably a reasonable middle ground here, balancing affordability with safety. For example, a 2009 Subaru Forester receives high marks for safety and according to Kelly Blue Book could be purchased for around $7,000.
I disagree. I have the cash to buy a car but still would take advantage of low Interest rate Auto loans and invest the cash. Buying used vs new is a different discussion. I prefer new cars specially with the recent advances in vehicular safety.
50K at 8% PA after 5 years 73,466.40
50K at 2% PA after 5 years 55,204.04.
If a man has poor financial discipline then yes, rather buy a depreciating ASSET than blow it off.
From a math perspective, it would make sense to borrow at 2% and invest at 5%. However, you can’t guarantee market returns. Moreover, from a behavioral perspective, paying cash for a car is more painful than financing it. The pain is what helps to keep your expenses low and win in the game of personal finance.