Let’s look at the pluses and minuses of buying a new car. Hopefully, it will illustrate why it’s best to avoid the new car trap.
New Car Pluses
- New car smell (it’s rumored to be toxic)
- No buyer’s remorse for at least a week
- Looking super-cool!
New Car Minuses
- 10-35% first year depreciation
- Average 50%-plus depreciation after three years
- Higher taxes and title
- Much higher insurance costs, especially collision coverage
Financing a Rapidly Depreciating Asset
Suffering that wicked depreciation and higher expenses across the board when buying a new car isn’t even the worst part. It’s the financing where they really get you.
Sometime after you finance that expensive new automobile, the market value of your now used car and your loan balance meet. As that car value continues to plummet from there, so does your ability to sell it. This is called being underwater on your loan. The higher the interest rate and longer the loan term, the faster and deeper you sink.
Don’t think you’re special because you can get one. Almost anyone can get a car loan. However, the worse your credit score and emptier your pocket the higher interest rate you pay. It doesn’t seem fair, but that’s the way it is. Best to avoid the new car trap altogether.
How Much Should You Pay?
If cars are your thing, and you want a newer car, buy last year’s model. You’re still saving on that wicked first year depreciation and will enjoy lower insurance, title, and taxes. Even if it’s only slightly used with less than 5,000 miles on it, you’ll save thousands versus buying a new car.
Obviously, the older the car and the more miles, the less expensive the car. Cars are built to last these days. A reliable piece of transportation can be had for just a few thousand dollars. There are so many better things to spend your money on than a new car.
A mentor of mine long ago told me to never spend more than 10% of your yearly income on your car. I’ve violated that edict a few times but have generally stuck to it, and I must say it has served me well. Sticking to 10% or even 15% enables you to save for a car and pay cash without bankrupting other more important financial goals like retirement, real estate acquisition, education, and fun.
How to Pay Cash
Even if you decide on a more economical mode of transportation, we’re still talking thousands of dollars you’ll need for purchase, which you probably don’t have just laying around. How can you purchase an automobile without financing? Set it up as a financial goal, but you need to be realistic as to what is affordable given your income.
Assume you have $20,000 budgeted for a new car. You clear $5,000 a month and can afford to set 10% of your net pay aside for purchase. It would take you 40 months to save $20,000, which is over three years. That’s too long.
Let’s apply my old mentor’s advice to the above situation. 10% of $60,000 is $6,000. Now you’ve got your savings period down to just 12 months. A year’s worth of savings for your car makes more sense than 3 plus years, and you can buy a fine ride these days with that amount.
Don’t think you need to successfully pay off an automobile loan over its entire original payment schedule just to improve your credit score. I’ve had a lot of folks tell me that over the years. Perhaps that was their justification for doing something they instinctively knew was wrong?
Yes, demonstrating your ability to pay on time and in full will help your score, but it’s costing you too much money. I recommend eliminating that auto loan and looking at other ways to help your score. There are lots of ways, but my favorite is to improve your credit score using a credit card. The best thing about it is it won’t cost you a penny in interest or fees. You must first promise, however, to never jeopardize your “transactor” status when using a credit card.
I’m adamant about you paying cash for your next new used car, but what if you already have a car loan? My advice is to put that high interest auto loan on your list of debt you want to eliminate, enact the best debt elimination plan, and pay it off early.
There’s a lot less regulation when it comes to car loans than mortgages, which means there are some frightful car loans floating around out there. Hopefully, you don’t have one of them. Look to see if your loan contract prevents you from using some of the money-saving tricks the best debt elimination plan employs.
Does your loan have a pre-payment penalty? Is it for the life of the loan or a shorter time frame? A prepayment penalty penalizes you for paying your loan off early. In the absence of a pre-payment penalty, is there a computed interest clause or other such verbiage committing you to paying all the loan interest originally owed?
This dastardly loan language lets you pay the loan off early, but you’re stuck paying all the interest originally computed per the amortization schedule. If you have one of these, you have my sympathies.
With most auto loans, you can add extra money to your regular amortized payment that goes strictly toward principal reduction. This reduces your principal balance faster than the original amortization schedule called for, thus reducing the amount of interest charged and shortening the time it takes to pay off the loan. Being able to reduce principal with an extra payment is at the heart of the best debt elimination plan.
Leasing a Car
Leasing a car can be the cheapest way to acquire a new car. Required down payments are usually lower for leases than new car financing. That doesn’t mean you should go out and lease one.
Remember the movie Groundhog Day with Bill Murray, where the same day kept repeating? A new car lease is kind of like that.
Car leases usually run for two or three years. Cars lose most of their value during that time. Once the lease is up, you lease another new car. Your lease payments over that time pays for the depreciation the bank suffered after you give them back the car, plus lots of fees, of course. You also pay for any “extra” wear and tear, and if you go over their maximum mileage allowance, they really sock it to you.
It’s like the movie because you suffer that most wicked of depreciation repeatedly, just as Bill Murray suffered having to hole up in Punxsutawney, Pennsylvania. No offense to folks from PA. It’s a beautiful place. I’m proud to have been born and raised in Macungie.
If you must have a new car every few years, you’re going to have to shell out a ton of extra money year after year versus avoiding the new car trap, whether you lease, purchase and finance, or even pay cash.
The new car trap is a skivvy, crooked racket that’s best avoided entirely. Over your lifetime, following this buy used, don’t finance philosophy, you can easily save six figures when you add up all the saved depreciation, fees, and interest paid, plus your savings on insurance, title, and taxes. There are not many strategies that can save you that kind of money. Avoiding the new car trap could be a game-changer!