Conventional “wisdom” says that there’s no way around having a car payment every month. Vehicles are just so expensive that there’s just no way a person can avoid it. You’re stuck with that $500 a month payment and have to deal with it for the rest of your life.
It turns out this conventional wisdom is not so wise after all. It’s total nonsense that a car payment has to be a permanent part of your life. We can choose to avoid the money pit and do things differently.
But why is this even something I’m writing about? Let’s consider a few facts about how car payments affect your financial future.
As of May 2018, the average car payment in America stands at a whopping $523 a month. That’s $523 that could be used to save for college, pay off your house early, or invest for retirement. Instead, most Americans have large portions of their household income going to vehicles. And many households have two payments of this size!
What’s the issue with making payments on a car, especially a reliable one? It’s the fact that all things with motors go down in value.
Over a five year period, $523 a month equals $31,380 total. What happens to that $31,380? It turns into about half of that or less in that time period. A car payment is one of the easiest ways to lose money over a long period of time.
When you purchase a car, its value immediately drops as soon as you leave the lot. A $30,000 car will lose about 20% in 30 seconds, and will continue losing value for the rest of its running life. How does that make for a better future?
The True Cost of Car Payments
What if instead of a $523 payment per month, you put that into a Roth IRA and chose good investments, even just index funds that track the S&P 500? Over a working lifetime, one could easily retire a millionaire.
Using a compound interest calculator, with an annual rate of return of about 10%, and a variance of 4%, here’s what your retirement account balance could look like.
If that’s in a Roth IRA, that’s all tax-free as well. What would you do with nearly three million dollars or more of tax-free money when you near retirement? I bet you’d want to do a lot of things!
But alas! The burden of a car payment makes that investment very difficult for many Americans. So what can be done about it?
Breaking Out of the Cycle
First, one can buy used cars. There are plenty of vehicles for sale that are reliable, safe, and will last for years. Just because a car has had a previous owner does not mean it is automatically unsafe.
If you do your homework and sharpen your negotiation skills, you can get a very nice used car for a much smaller price tag than a brand new one. (Check out my guide on how to buy a used car here).
Second, decide to not borrow money for cars in the future. If you currently have a car payment, apply it to your debt snowball, and aggressively pay it off as fast as you can.
Once you have it paid off, drive it for a while. There’s no need to rush into more debt! Once you have no debt, you can then take that same car payment, save it into a money market account or high-interest savings account, and by the time you need to replace your car, you’ll have built up a pile of cash you can then use to write a check and drive off the lot still debt-free.
How much car should you purchase? A good rule of thumb is that the total value of all vehicles in your household should not equal more than half of your annual household income. Otherwise, you have too much money tied up in things that are going down in value.
If you make $50,000 a year, a $30,000 car would be too high. $20,000 would be more reasonable, but I would probably aim for about $15,000 or even $12,000. You can still get a very nice car in this price range.
Want to hear about a way to have a “free” car? If you plan on driving your cars for 7-10 years at a time, you could put what would have been your monthly payment into an investment account, let it grow over that period of time, and use the growth to pay for your next car.
This would only really work if you plan on keeping your cars around for a while; that will give the market time to adjust from any down periods. But if you create a good-sized nest egg in a solid mutual fund, you could just use the account’s growth to pay for each car you buy in the future.
Car payments do not have to be a permanent part of your life. You can choose to take a different path, the path that most American millionaires follow. Almost none of them have a car payment, maybe minus the first one they had early in their lives. They specifically avoided those payments, and instead saved and invested, and that’s how they became wealthy.
Not sure if you can do it? I can help!