How To Buy a Car That Doesn't Kill Your Finances

If you live in the United States, the chances of you needing a car to get to work or run errands are high. Cars allow us the freedom to drive anywhere. While a car is a necessity, it can be a wealth killer if bought incorrectly. Let me explain

When it comes to cars, many fall into the trap of buying more car than they can afford. Cars in American culture are a symbol of perceived status. When you buy a new car, you let your emotions drive you to pick a car where you want to impress others. This leads you to buy a car that is higher than you can afford, financing it for a long time so that you “look like you are winning with money.” The cost of owning that car makes up over 30% of your income. The reality is that years later, the value of your car has dropped and you are stuck with high payments. You now realize that you are underwater in your car. You begin stressing out how to make the payments or else the car is going to get repoed.

There is also more to the cost of a car than what you pay for it. There are 4 hidden costs that you need to be aware of when buying a car. Not factoring these in could hurt you financially

The Hidden Costs of Buying a Car

1. Depreciation

   Depreciation Hits Hard. A new car loses up to 63% of its value in the first 5 years. That's money that you can't recover, a steep price for the convenience of driving off the dealership lot in a new ride.

2. Cost of Financing

   Most car owners finance their purchases, incurring interest that adds to the total cost of the vehicle. Financing a depreciating asset amplifies your financial losses. A high car payment lowers your monthly cash flow

3. Maintenance

   To keep your car running in good condition, you will need to schedule oil changes, purchase new tires, fix any leaks, etc. These costs are small, but they add up over time. Buying reliable car brands such as a Honda or Toyota, can help keep maintenance costs low

4. Insurance

   Insurance is a necessary expense if you are driving a car. Without insurance, you can put yourself in a deep financial hole. Car insurance protects you from liability and collision damages. If put in the hospital, your insurance is there to help take most of the financial hit. While insurance is great to have, it is a hidden cost that many car buyers don’t take into account

How To Buy A Car So That it Doesn’t Kill Your Wealth

If you are in the market for buying a new car, you have 3 options: buy in full with cash, lease, and finance.

Buying a car in cash is actually as it sounds, you save up for the total price of the car listed and don’t take out any loans to finance the purchase. This is the most ideal decision and I will explain why later.

Leasing a car is when you rent the car for a certain time period, usually 3 years, paying a monthly payment, then returning the vehicle back to the dealership. The payments you make are often lower than the payments you would make if you financed the car. If you lease a car you don’t build any equity in the car.

Financing a car is getting a loan to purchase the car and paying monthly payments. Example: You want to buy a $30,000 car. You put 20% down ($6,000) and finance the rest ($24,000). You pay $600/mo over 5 years, then once the loan is paid off, you own the vehicle outright. The majority of car purchases are financed. Most of the time it doesn’t make sense to finance a depreciating asset like a car, but there are times when it does.

When Does it Make Sense to Finance?

• Financing a car is solely dependent on interest rates.

  • If interest rates are high, the cost of owning the car will be higher because of higher interest payments. Thus increasing the opportunity cost of not financing

  • If the interest rate on your car loan is greater than 3%, I would consider paying the car in cash instead of financing

• Use the 20/3/8 Rule

  • The Money Guy Show has this amazing car-buying rule that helps you not spend more than what you can afford on a new car

  • 20: 20% down payment

  • 3: don’t finance for more than 3 years (36 months)

  • 8: the monthly cost of your car should not be more than 8% of your income

  

• Example of Buying a Car You Can Afford

  • Figure out how much car you can afford. Let’s say you make $3000 per month. Your car payment should be less than 8% of your income (0.08 * 3000 =$240). Now, plug in your estimated interest rate based on your credit score and the total months for the loan. Let’s say you have a 700 credit score. That will get you around a 12% interest rate at current rates. We want to keep the interest expense as low as possible so we will finance for 36 months. If you want to buy a car you can afford based on these assumptions, you can finance a car up to $7225. This is the total loan amount. If you have no down payment, then the price of the car you can afford is $7225. If you can save for a down payment of $3000, you can afford a $10,000 car because you would put the down payment and finance the remaining $7000, which is below the $7225.

  • If you have a low credit score (less than 730), financing a car should be a last resort because your low score will result in higher interest rates and higher monthly payments, which will add to a higher total cost of the car you buy

The Opportunity Cost to Financing:

If you go to the financing route, you need to consider the opportunity cost associated with it. As interest rates increase, the opportunity cost of financing a depreciating asset also increases.

According to LendingTree, the average car payment in America in 2024 is $735, and the average loan term is 5 years (60 months). After 5 years, your $33,000 car is worth $15,510, but you paid a total cost of $44,100. Ouch.

Imagine redirecting your typical car payment and investing it over the same period of the car loan. Instead of paying the bank $735/month, you invest it in the stock market and earn a 7% annualized return. Over the same period of a car loan, your $735/month contribution will get you to $52,328.96, showing what you might miss by locking up your money in a depreciating asset.

Now, what happens if we invest this over 20 years? Consistent investing instead of car payments could lead to a potential nest egg of around $373,000. That's a substantial amount for retirement or other financial goals. This is the long term impact of investing over paying a payment for a car

Why Buying a New Car in Cash is Ideal

1. Avoiding Interest Payments

• No Financing Costs: When you buy a car with cash, you avoid paying interest on a car loan. Over the life of a loan, interest can add a significant amount to the total cost of the vehicle.

• Lower Total Cost: Since you're not paying interest, the overall cost of the car is lower compared to financing, where the final amount paid often exceeds the original price due to interest.

2. No Monthly Payments

• Immediate Ownership: Paying cash means you own the car outright from day one, with no monthly loan payments hanging over your head. This frees up your monthly budget for other expenses or savings. Without the obligation of a monthly car payment, you have greater flexibility in managing your finances, which can be especially beneficial in times of financial uncertainty.

3. Full Ownership and Flexibility

• Freedom to Sell or Trade: Since you own the car outright, you have the flexibility to sell or trade it at any time without worrying about loan payoffs or dealing with negative equity. When you finance a car, the lender holds the title until the loan is paid off, which can complicate selling or trading the vehicle. Cash purchases give you full control of the title and the vehicle.

4. Psychological Benefits

• Debt-Free Satisfaction: Owning a car outright with no associated debt can provide a significant sense of accomplishment and financial security. You won’t have to worry about making monthly payments or the stress that comes with carrying debt, which can lead to better financial well-being

Does It Matter What Car Brand I Choose?

The car brand you choose also matters as some brands are more reliable than others resulting in cheaper maintenance expenses. Here are the top 5 cars driven by millionaires

Top 5 Cars Driven By Millionaires

1. Toyota

2. Honda

3. Ford

4. BMW

5. Chevy

Since the the 1990s, Toyota and Honda have ranked top 3 on most reliable cars to own and the most owned by millionaires

Is There an Optimal Time to Buy a Car?

When you buy a car also matters. Here’s the best time to buy a car

• October-January: car dealerships are getting new inventory and have to make room. To make room, they lower the prices of the cars on hand

• End of the month: Car salesmen earn money on commission. Their incentive is to get you to buy a car. If they don’t make a certain sales quota, this puts their job at risk. Going at the end of the month when sales quotas are due can put an advantage on your side because the car salesman has more incentive to sell you a car at a better deal than not selling anything.

When you buy at the end of the month and in the months between October-January, you as the buyer have the advantage of getting the best deal

Buy In The Sweet Spot

Look for cars that are 3-5 years old and have 30-50k miles on them. You minimize the depreciating impact by buying a little older car, and get a “new” car that hasn’t been used much. If rates are less than 3% and the monthly payment is less than 8% of your monthly income, consider financing the purchase. If not, save up and pay cash.

Summary

Buying a car is one of the most significant buying decisions we make in our lifetime. Don’t let it kill your wealth. Buy a reliable car and don’t over pay for it. The cost of not doing this correctly could cost you hundreds of thousands of dollars.

Thanks for reading! If you’ve found this helpful when it comes to buying your next car, please subscribe to the newsletter

Best, Matt