I have seen and read a lot of tweets and blog posts lately that say the key to being financially independent is never buy a new car. These posts are mostly filled with the typical writer talking about mistakes they made in the past. Although that is good, it is misleading and incorrect to attribute reaching or not reaching financial independence.
Our hypothetical person for the sake of this post is 30 years old and is a college graduate. This person is single and makes just a tad bit more than the LA median salary of $62,000 LA Median Salary
I will list different scenarios. Some of them will be detailed and others will be self-explanatory.
Scenario A: Renting, credit card debt, student loan debt, and no financial strategy.
Do not buy a new car. Do not buy a car if you don’t need it. If you do need a car, buy a used junker that successfully gets you from point A to B. Self-explanatory that financing any sort of car, new or used, is absolutely not in your best interest.
Scenario B: Renting, no debt, contributing enough to get company match in 401k, 3 months emergency fund.
Do not buy a new car. Same answer as scenario A. Work on saving money to increase emergency fund to 6 months and contributing more to tax deferred investment accounts. Real Estate is tricky and we won’t get into that but decide at this stage what is more important, owning property or purchasing a new car. Either way save money for that goal.
Scenario C: Renting, maxed out 401k, 6 month emergency fund, no debt.
Bi-weekly Gross Pay $2,500.00
Federal Withholding $214.02
Social Security $113.15
Net Pay $1,389.01
A dealer will “qualify” you to purchase a car based on what you can afford. Never ever tell them what you can afford. Focus on the overall price first and keep in mind the length of loan you should do to keep you finances in line
So what can you afford to buy? A simple rule of thumb to find out what the maximum you could afford is the 20/10/4 rule. Make a down payment of at least 20%. Finance a car for no more than four years. And not let your total monthly vehicle expense, including principal, interest and insurance, exceed 10% of your gross income.
So making $65,000 before taxes would allow you to purchase a car for $22,750 with a 3% interest rate financed for 4 years which ironically calculates a monthly payment of $503.
So if you choose to buy a new car this is the most you can spend without a down payment of 20%. The reason you want to put some money down is to pay off that depreciation that will happen within 30 seconds of you driving it out of the dealership.
This information is so very important because the dealer is going to up sell you and tell you that since you could afford $503 a month, you could afford more car for a longer term. Don’t be fooled by this. You could also afford a solid used car for this amount but your interest rate will be higher just because the car is older.
Your car payment will be $393 for 48 months if you utilize a 20% down payment.
10% of a $65,000 gross salary is $541 per month.
After car payment, insurance, fuel, the estimated monthly amount left over for remaining expenses should be around $800.
Ask yourself if maxing out or going above your maximum will ever help you achieve financial independence? The answer is no. It’s possibly but the odds are stacked against you.
I would recommend this person stick with the answer from Scenario A and B. But if buying a car is high on the personal priority list it would be best to purchase a vehicle that will retain some value and purchase something that is $15,000 or less. Which if anyone has been to a dealership knows this is hard to find.
It’s not surprising that consumers get suckered into buying much more car than they can afford. And yes this will hurt your goal of achieving financial independence in a timely manner.
Scenario D: You skipped A,B, and C and currently are financing a vehicle.
Let’s assume you purchased a car and currently have a monthly payment of $503 per month for a period of 5 years.
What do you do?
The FI community will tell you to aggressively pay off this car loan. Let’s say you can afford to pay an extra $250 per month.
Option 1: Pay $753 per month towards the car. You will have a paid off car in about 3 and half years with a value of $15,120.
Option 2: Pay the minimum amount of $503 per month for 60 months and put the $250 a month into a brokerage account assuming 6% returns you would have a paid off car worth about $10,000 and about $17,500 in a brokerage account. Combine those two at year 5 you have $27,500.
The numbers don’t lie and here is how you can still work towards your goal of FI while paying off debt. Of course if you never had that car payment in the first place there would be better numbers.
Point is if you are stuck in a car loan, it’s not the end of the world if you manage your debt and use money as a tool. A tool that grows.
|Existing Payment Schedule||Accelerated Payment Schedule|
Investment Results by Year
|Year||Balance||Balance After||Taxes||Balance After||Inflation and Taxes|
|$250||Starting Balance $250||Starting Balance $250|