I'm a big fan of using simple rules to help people make easier and better financial decisions. Developing simple rules is a lot easier said than done, as there are a range of viewpoints to consider.
When building rules for car buying, I considered the following questions among others: How do I build rules that prevent people from overspending on a car, allow rich people to buy nice cars if they want, is reasonable for people buying their first car, and allows car enthusiasts to stretch a little on buying a car?
I narrowed car buying down into two phases. Phase 1 looks at rules for people who are broke, but need to buy a car (I define being broke as having negative net worth and not having anything saved for retirement). Phase 2 is for those who have a positive net worth, are saving for retirement, and who want/ need to buy a car.
Here are NinjaPiggy's car buying rules for Phase 2.
Phase 2 Car Buying Rules:
1. Pay Cash
If you can’t save enough cash you are either buying too expensive of a car or you are broke. If you are broke, read “You're Broke, But Need a Car.” Even if you can get 0.0% APR on the car payments, still pay cash.
Paying cash helps prevent car buying from ruining your financial situation. Taking time to save up money to pay for a car, gives you more time to assess how much you really want to spend.
Step foot on a car dealership lot and you’re sure to hear a salesman ask you, “What do you want your monthly payment to be?” Let’s say you plan on financing a car for a fairly typical 6 years (72 months) at 5%. If you buy a $15,000 vehicle you will pay about $240/month. The salesman might then turn your attention to a “slightly” more expensive vehicle that will only cost you $80 more at about $320/month.
You'll immediately start thinking about how you could easily “afford” the extra $80/month by cutting a thing or two out of your budget (but let’s be real, you’ll never get around to actually cutting it out). The extra $80/month means buying a $20,000 car instead of $15,000; a $5,000 difference. It’s easy to talk yourself into spending an extra $80/month. It’s a lot more difficult having the patience to save up the extra $5,000.
Paying cash is a complete mindset shift. Instead of finding ways to justify a higher monthly payment, you may find yourself thinking of other things to do with your money, if you buy a less expensive vehicle. If you have $20,000 saved for a car, it could also mean a $12,000 vehicle and $8,000 to spend/save/invest on something more aligned with your goals.
It can be tempting to get lured in by 0% interest financing. My take is you should still pay cash even if you qualify for 0% interest. If you feel paying cash for a vehicle is painful, I agree. It should be painful. Financing may make it easier to get into a vehicle, but you need to feel the hit to your net worth. Don't get conditioned into making a car payment. It's a financially dangerous habit to develop. Pay cash for your vehicle.
2. Have a Net Worth Mindset
Even if you pay cash for a vehicle, you still might be overspending. Your net worth statement is your ultimate financial scorecard. You’ll (hopefully) get to the point where you are no longer working and will need to turn your assets into an income source. Every time you make a major financial decision, you need to be aware of the impact it will have on your net worth. Whether you decide to hold off on a purchase or not, by being mindful of your net worth you’ll at least be making an informed decision. Whether we want to acknowledge it or not, major financial decisions have significant long-term implications.
When you buy a car, you are buying a depreciating asset. Putting too much money into a depreciating asset will destroy your net worth. If you have to (or want to) buy a car, you can dramatically improve your net worth over time by buying a less expensive one and investing the rest.
3. Spend No More Than 10% - 20% of Your Annual Income
Every time I give a spending rule, I reminded of a quote I once heard, “people aren’t looking for advice, they are looking for permission.” (Sadly, I can’t remember who said it to and a Google search came up empty.) With massive amounts of personal finance advice out there, it’s easy for people to search and search until they find someone that gives advice that validates the decision they've already made. This type of thinking is very counterproductive. Oftentimes, the best financial advice is a little uncomfortable (at least at first).
I’ll always be okay with spending less on a reliable vehicle, but most people tend to ask “what’s the most I should spend on a car?” While I’m concerned giving far too restrictive of a ratio will lead people to ignore my advice and seek out less restrictive advice, I can only give advice I believe in.
One of the most thought-provoking personal finance blog posts I've ever read is Financial Samurai's, "The 1/10th Rule For Car Buying Everyone Must Follow." I initially was skeptical of the 1/10th (10%) rule, but after reading it a couple of times, something clicked. We as Americans do spend way too much on cars, and car buying stands in the way of wealth building. As Financial Samurai would say, "if you want to spend more on a car, make more money."
Spending only 10% of your income on a vehicle may be ideal, but I'm also a realist. Spend up to 20% of your income if you must, but don't exceed 20% if you care about your financial future. As a simple rule, I find the more you have to justify a financial decision, the more likely it is you overspent. Keep your car purchase price between 10%-20% of your annual income to avoid overspending.
4. Plan on Driving Your Car For At Least 10 Years
There is a saying about the most affordable car is the one you already own. You should plan on driving your car for ten years or longer if you can. Reliability in cars has greatly improved over the last few decades, making this a pretty easy proposition. Stretching the amount of time between vehicle purchase will allow you to save a lot of money over the long run.
For a great illustration on why it make sense to own a car for at least 10 years, checkout "The Tale of Two Swines."
5. Take Care of Your Vehicle
If you buy a newer model vehicle you should have no problem keeping it running for ten years, provided you take proper care of your vehicle. Foregoing needed maintenance isn’t frugal, it’s stupid. Keep up with your vehicle’s maintenance. It will keep your vehicle running longer, and can prevent even more costly repairs.
If you aren't comfortable doing maintenance on your own vehicle (I know I'm not), find a trusted and reliable place to take it. Don't always just go for the cheapest place. The repair shop I use has great reviews, fair pricing and most importantly, I trust them. Some car repair shops will give you a list of recommended maintenance items, and they'll make it sound like your car will blow up if you don't get them all taken care of immediately. I appreciate my shop informing me what repairs are the most urgent, and which repairs can wait awhile.
6. Be Cautious About Splurging
Once you set a standard with size, power and amenities it’s hard to downgrade on future cars. Be aware that splurging for a few extra features may be changing your car buying habits for the rest of your life. It’s easy to get accustomed to premium features, so much so, that you’ll never accept anything less.
Being an early adapter to new technology can be expensive. Technology costs come down over time, so holding out on some new features can save you a lot of money. There is a ton of progress being made on autonomous (self-driving) vehicles. Over the next few years, more and more new vehicles will have different stages of autonomy. As tempting as it may be to run out and be the "first" (along with thousands of others) to have something, you will be rewarded with lower prices if you exercise patience.
If you do decide to pay up for extra features, make sure they are beneficial features. A car salesman may be able to sell you on a feature that sounds neat at the car dealership, but you might end up finding it unnecessary and gimmicky once you drive it off the lot.
7. Mo’ Money (Spent on a Vehicle), Mo' (Expensive) Problems
Sometimes it pays to pay up for quality. When it comes to car buying, I'm not so sure that's the case. Not only do premium cars come with a more expensive price tag, they are also more costly to maintain. When determining the cost of a vehicle, you have to look beyond the purchase price.
How much will repairs cost? How much will you spend on gas, insurance, registration, and taxes? The proper way to evaluate the true cost of your vehicle is by calculating your cost per mile (CPM).
Calculate your total cost per mile (CPM) to see how an expensive car really impacts your total cost.
8. Don’t Count on Luck to Bail You Out
I’ve seen people get bailed out by dumb luck when they buy a house. What's dumb luck you ask? Dumb luck is when a person buys way more house than they can afford, but soaring home values end up making them lots of money when they sell. This won’t happen with your car. Home values tend to go up over time, car values do go down over time. Expect your car to go down in value because it will.
When you buy a car that is too expensive, you’re stuck with two options. Hold onto the car until it’s paid off, or sell it for (far) less than you paid for it. Don't let this happen to you. Be smart about buying a car on the front end, so you aren't forced to one day sell at a loss.
9. Shop 3-Year Old Cars
A car depreciates quite a bit in the first year; usually somewhere between 15% to 25% depending on the trim level. It slows down quite a bit for year two and three, but, as a general rule, the depreciation for the first three years will exceed the total depreciation from years four through ten! Buying a used car that is 2-3 years is usually a much better financial decision vs. buying new. If you buy new it’s critical that your get as much off the MSRP as possible as well as hold the car for as long as possible. Whether you are buying new or old, shop around and negotiate to get the best value.
10. Evaluate Transaction Costs
If you are selling your old car, in addition to buying a “new” car, make sure to evaluate all of your options. Trade-Ins don’t often give you fair value. You don’t have to do a Craigslist transaction but reviewing your options can save you quite a bit!
You'll probably be spending some time shopping around to find the best deal on the vehicle you are going to purchase. Devote some time to maximizing the amount you get for your current vehicle. Many people get lazy on selling their vehicle and end up accepting thousands less than the car is worth.