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The end of World War II was the start of a consumer boom in America. Thousands of veterans were returning home, with the dream of starting their own families and with the hope of a better future. This disrupted two markets in the 1950s which changed the face of American culture forever – Housing and cars.
America is synonymous with cars. Starting with the “hot rod” culture in the 50s and the evolution of the “Big Three” as some of the largest companies in the world, a large part of US infrastructure was also built around a car-centric way of life. This also led to the growth of infrastructure and business models that were uniquely American – From wide interstate highways and suburban housing, to billboard advertising and drive-in restaurants.
To add some context: At the start of the 1950s, there were just 25 million registered automobiles on American roads. Right now, there are about 278 million registered vehicles in the US, and 91.7% of households have at least one vehicle. This means that there are more Americans without emergency savings than there are without a car! There’s something about a car that just gives you a feeling of freedom, control, security, and joy – as a car buff myself, some of the happiest times of my life were spent behind a wheel, with some music on the stereo and zooming down the highway.
But cars aren’t just utilities – they’re also status symbols. Elon Musk understood when making Teslas that a car can be good for the environment, but it has to first be a great car and that people need to actually want it. But this “man in the Ferrari” effect can actually cost you way more than you can afford sometimes. From an investment standpoint, cars are the bottom tier. For something that sits idle for 92% of the time, they can cost an awful lot of money and according to Morgan Stanley, “cars are the world’s most underutilized asset.”
Add financing, FOMO, and an inflated second-hand car market to the mix, and buying an expensive car could be a terrible mistake. In a survey of 1000+ people, two-thirds of people said that they had to cut back on other spending due to their car payments, and a quarter of them had to even cut down on grocery spending! That need not be you. There’s a way to plan this out properly.
Here’s how you can spend responsibly on a car that you like after understanding the hidden costs, how much you need to earn to afford every price point, and which cars could save or even make you money a few years down the line.
Cost ≠ Price
Monthly payments on cars can be as high as $800 now, and you’d need to be making an absurd amount of money to afford that. But just like homeownership, the monthly cost of owning a car is not the same as the monthly payment. Here are the reasons:
Financing: 85% of new vehicles and 55% of used vehicles are bought with debt, and many of these are spread out over a long period of time (more than 3 years). The average car loan debt is $26,162. This ends up costing people much more than the car is worth. 25-50% of those loans are given to people who might not be able to pay it back, on a term of at least two years. With interest rates now at anywhere from 6.8 to 13%, you’ll have to budget for a monthly payment that lasts at least a few years.
Fuel costs: The car is just the first of your expenses – A lot is going to depend on whether you drive a fuel-efficient car like a Prius or a gas guzzler like a Hummer H1. With an average fuel cost of 25.4 miles per gallon and 41 miles a day in commute, you're looking at about $150 in fuel costs per month.
Insurance: This is going to depend on your age, driving history, car, location, miles driven, education, and many other factors. It can average around $170 a month, and the costs will be higher if you're under the age of 25. It’s a tricky trade-off because a car can help you move around and make the most of your youth, but it eats into the capital that you can invest elsewhere.
Car registration: Every year your state is going to charge you a fixed price based on the MSRP (purchase price of your vehicle), and this could cost you a few hundred a year.
Maintenance and repairs: High-end cars like a Porsche, BMW, or a Mercedes might require high maintenance unlike a Toyota or a Honda.
Depreciation: This is something that most people never talk about, but which is absolutely essential. Generally speaking, a car loses 11% of its value the moment you drive it off the lot and within 5 years, it’s worth 63% less than a new car.
There are some cars that can retain or even appreciate value with time (but more on that later).
Keeping all of this in mind, here’s the most general rule that you can apply if you want to buy a car that satisfies your commuting needs while not eating into a huge chunk of your income.
The 20/3/8 rule
This is a simple rule suggested by The Money Guys to figure out how much car you can afford, which has three parts:
Put down at least a 20% down payment. This ensures a lower interest rate and also reduces the chances that you'll be upside down on your loan the moment you drive the car off the lot.
Pay off your loan in 3 years or less. The average ownership lifetime of a car in the US is 79.2 months. So if you go for a 72-month loan, you'll perpetually be in debt, buying a new car just as you pay off the old one. Go for a shorter-duration loan and pay off your car loan, so that you can reduce the psychological burden associated with it.
8% of your annual income should go to transport costs, no more. This is because vehicles are depreciating assets, and investing more than that will not give you a good return on investment, so it's better to keep it low and invest that amount elsewhere.
Let's do a breakdown with an example: If you earn $45,000 a year, you can afford 8% of that on transport costs. This comes down to $3,600 a year, or about $300 per month. If you put down a 20% downpayment of $1,600 on a car that costs $8000, your monthly car payment comes out to $200. You have around $100 left for gasoline, maintenance, insurance, etc. (which is tight but manageable depending on the car and your terms).
At different price ranges, these are the cars you can afford:
An $8000 car at a $45,000 income
A $16,000 car at a $75,000 income
A $26,000 car at a $125,000 income
A $40,000 car at a $200,000 income
This strategy is for the financially conservative who want to live below their means, pay down their loan fast, and optimize their transport costs so that they can invest their savings elsewhere.
But waiting till you make $200,000 to buy a $26,000 car is somewhat unrealistic, especially with the average used car price being $26,510. So if you are more of a car aficionado who prioritizes life experience over investment returns, there’s a slightly more flexible strategy.
The 20/4/10 rule
This equates to a 20% down payment, over a term of no more than 4 years, with 10% of your budget going towards transport costs. This lets you afford considerably higher-range cars. But the downside is that you pay more on transport while extending your loan term by a year.
For example, on an income of $50,000 per year, the 20/4/10 rule would allow you to buy a car in the $16,000 range, which would result in a $300 car payment and $100 left over for everything else. And for different income ranges, this is how it would work out:
The downside is that you wind up paying slightly more of your income towards transportation, while at the same time extending out the term of the loan for an extra year. So it’s doable, but if your focus is on building long-term wealth and retiring early, this is not the approach. For that, we have the
The Dave Ramsey method
Dave Ramsey is one of the most knowledgeable and successful personal finance experts of our time with over $600 million of real estate that is fully paid off. He has a very different philosophy regarding buying a car, because his approach is centered around building wealth and becoming a millionaire. His emphasis is on making the approach apply to a wide audience with as little deviation as possible, and he has just two pointers:
Don't buy a car that you can't afford with cash
Your car should be worth 50% or less of your annual income
His reasoning is simple – The novelty of a new car wears off after a while. It’s the functionality that matters, whereas the money you save and the psychological comfort from being debt-free go a long way. He also found by surveying 10,000 US-based millionaires, that the average millionaire is debt-free driving cars with 41,000 miles on them by the end of the fourth year. 8 out of 10 drive it away debt-free without carrying a car payment.
The worst car accidents happen on the showroom floor.
– Dave Ramsey
Another opinion from the Financial Samurai blog is to spend no more than 10% of your income on a car that you intend to keep for 10 years. Though this might seem excessive, the reality is:
Owning a cheap, reliable car lets you save money that you can spend elsewhere.
Being debt-free is a huge psychological advantage.
You get more money that you can use to maximize your enjoyment in other areas of life.
All of these rules are centered around being financially responsible and fitting your car purchase into a life of building wealth and being financially independent. On the other hand, dealerships will let you buy almost anything that you can qualify for. Just because you qualify for something doesn't mean it's a wise choice. Here's where things get shocking…
The dark truth of dealerships
See, dealers don’t really care about your financial health. They aren’t concerned with how the car affects your long-term financial plans and whether this is a prudent purchase. All they’re worried about is whether you can afford the monthly payments, and to do that, they look at something called the Debt-to-Income ratio.
The DTI is the proportion of your expenses and debts (after car payments) compared to your monthly income. If it's less than 45%, dealers will have no problem approving the purchase. For example, if you're earning $5000 a month, 45% of that is $2,250. If you spend $700 a month on student loans and credit card loans, that leaves you with $1,550 that the dealer will gladly finance.
But that's the problem – Just because a lender is willing to finance you doesn't mean it's a good choice, because the same car could be a good deal or a bad deal for a lender depending upon the terms, but in the long term, it's going to cost you the same amount.
For example:
If you earn $6,000 a month and spend $1,500 on rent, loans, and credit card payments, your DTI is 25%.
The lender will be willing to finance the remaining 20%, which is $1,200 a month.
At $1,200 a month on a 3-year loan with no money down, you cannot afford a Mercedes Benz C-Class which costs $65,000 because your payments cost $1,976.
On a 6-year loan though, your payments drop down to $1,100 a month and you can suddenly afford it on financing. But in the long run, you'll be paying $78,000 for the car! Just because the lender is willing to finance it, doesn't mean you should go for it. According to Dave Ramsey's rule, this car would have been a strict no-no if you're interested in building wealth.
Let's put it this way. If your monthly budget is $500 for car payments, you can afford:
A $16,000 car over 3 years or
A $30,000 car over 6 years
The second one might look more tempting, but it'll cost you more in the long run with less return on investment. Some lenders even offer flexible terms going up to 96 months, which can expand your perceived budget to $37,000 but sink your investment goals in the long run.
How are lenders able to confidently give you the loans if it might not be a financially wise decision for you? The truth is, lenders just need you to make your payments diligently for the first few months – after that, they can just resell the loan to a third party. This gives them a quick profit and the excess cash lets them rinse and repeat the process with new customers.
Dealerships don't have your best interests at heart. That’s why it’s very important to come up with a budget ahead of time and stick with it because your emotions can play havoc at the time of the sale.
Best of both worlds
Though Dave Ramsey’s rule and the 20/30/8 rule are sound pieces of advice, as a car enthusiast myself, I do get the appeal of owning and driving great cars. Fortunately, there’s a way where you can be smart about buying cars and possibly even make money from them over a few years.
The first car I ever bought was a used 2005 Toyota Prius. It cost me $8,500 and it had 70,000 miles on the clock. I drove that car for about 4 years and put on another 50,000 miles. I sold it for $5,500. I lost only $62 a month in depreciation!
Around the same time, I bought a higher-end car – A 2006 Lotus Elise – for $30,000 in cash. I drove it for two years, and then I sold it at $30,000. I then bought a Lotus Exige S240 for $49,000. I drove it for two years and sold it, again for $49,000.
The same goes for the cars I currently own: My 2005 Ford GT and my Tesla Model 3, which are both worth more than what I paid for them. Generally, anything I drive retains its value and sometimes I end up even making money. I'm a car fanatic and I'm very particular about buying something that doesn’t plummet in value. In my personal opinion, a car that could work for a strategy like this might include:
The Honda S2000
An older Mazda Miata
Mid-2000s Corvettes
Mid-2000s BMW M3s
Early 2000s Porsche Boxsters
A used Subaru Impreza
The Toyota FJ Cruiser
Late 2000s Audi R8s
A used Mercedes G-Wagon
If you have a lot of money, there's also:
The BMW Z8
Any Manual Ferrari F430, or Lamborghini
Mercedes SLS AMG
Any Dodge Viper
All of these are very specific specialty cars, but there’s a market for them and because of that, their values tend to climb. It's a specialized field and you have to do your own research. These are not recommendations or suggestions, just a starting point to give you an idea of the niche market out there.
If you want to be on the safer side, you could buy a more commuter-friendly car. This would be a car that’s 5-7 years old with about 30,000 to 50,000 miles on the clock that you could easily drive without any major issues for the next 5 to 15 years – like a Toyota, Honda, Accura, or Ford. It should be used, reliable, good on gas, and affordable with less than 10% of your salary over three years. Think about buying it with cash and the benefits that come with it.
For everything else, keep your payments to a minimum. Keep your car insured at all times and pay attention to minimizing the other costs. Finding a good local mechanic whom you can trust with regular maintenance can drive down your expenses by a lot. The truth is that in the grand scheme of building wealth, cars are just a money pit that distract from the things that matter the most – functionality, freedom, and optimizing for what you enjoy.
Stay safe, stay invested, and I’ll see you next week – Graham Stephan.
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Disclaimer: This is not financial advice. This information is intended to supplement your knowledge in the field of investing and personal finance. Please do your own research carefully.