Money

Why you should buy a used car—and pay a lot less money than you think

 

I watched in horror as a total of 690,000 new vehicles averaging $24,000 each were sold under the Cash For Clunkers program in 2009. The government's $4,000 rebate for trading in your car ended up hurting hundred of thousands of people's finances instead: Your $20,000 invested in 2009 in the S&P 500 index would now be worth over $50,000 today, given that the stock markets are now at record highs.

Buying too much car is one of the easiest and biggest financial mistakes someone can make. Besides the purchase price of a car, you've got to also pay car insurance, maintenance, parking tickets, and traffic tickets.

When you add everything up, I'm pretty sure you'll be shocked at how much it really costs to own a car!

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The 1/10th rule for car buying is simple. Spend no more than 1/10th your gross annual income on the purchase price of a car. If you make the median per capita income of ~$42,000 a year, limit your vehicle purchase price to $4,200 if you must buy one. Absolutely do not go and spend the median car price of $34,000!

A median income earner buying the median priced car that now costs $34,000 in 2018 is financial suicide. Who spends ~81 percent of their gross salary on the purchase price of a car? Worse yet, after you pay a 20 percent effective tax rate on your median $42,000 gross per capita income, you're now spending ~95 percent of your net income on a car!

That's crazy and a sure path to financial mediocrity. Don't expect the government or your rich uncle to bail you out.

Why you shouldn't spend more than 10 percent gross on a car

1) Maintenance costs. The more you drive, the more you will pay to maintain your vehicle. With thousands of parts per car, something will inevitably break or need upgrading. You've also got to pay for insurance, parking tickets, and traffic tickets. The thrill of owning a new or new used car lasts for only several months, but the pain of paying the same car payment lasts for years.

2) Opportunity cost. When you buy a car you lose the opportunity of investing your money in assets that will likely grow and pay you dividends in the future. Everybody knows to save early and often to allow for the effects of compounding. Buying too much car is like negative compounding! Imagine how much money you would have accumulated if you invested $300-$500 a month in the stock market since 2009 instead of paying for a car.

3) Stress. When you pay more than 1/10th your income for a car, you will become more stressed. You'll feel stressed whenever you get a door ding after parking your car at the local grocery store. You'll get stressed whenever you incur wheel rash after parallel parking too close to the curb. Sometimes when you're driving in traffic, you'll feel more on edge because you don't want anybody damaging your car.

If you are within 1/10th of your income, you drive and park, stress-free. You stop caring about door dings, bumper scrapes, even break-ins. Stress kills, folks.

4) It makes you want more. The nicer your car, the more you want to spend on other things. You start thinking stupid thoughts like, "I've got to buy a matching chronometer watch, driving shoes, and outfit." You start paying $20 for valet because you want people to see you come out of your car instead of park for free.

5) It makes you feel stupid. Deep down, you know that if you can't pay cash for your car, you can't afford the car. Each payment you make is a reminder how foolish you are with your money. Why would you want to be reminded every single month of being dumb? Again, the thrill of owning a nice car fades after about six months, but the payment stays the same for years.

If you've already bought too much car

Look, everybody makes dumb financial moves all the time. The important thing is to recognize your mistake, stop, and fix it.

Here are some things you can do if you've bought too much car.

1) Own your car until it becomes worth 10 percent of your income or less. This is the simplest solution if you've spent too much. Drive your car for as long as possible until the market value is worth less than 10 percent of your gross annual income.

2) Bite the bullet and sell your car. If you've spent anything more than 1/5th your gross annual income on a car, I'd sell it. It's making you poor. Even if you have to take a little bit of a hit, I think it's worth getting rid of your vehicle.

Don't trade it into the dealer because you'll get railroaded. Instead, try negotiating via Craigslist.

3) Punish yourself. If you don't punish yourself, then you will repeat your mistake and feel fine with what you have now. For the life of your car loan, take away a food you love to eat, such as chocolate. If you are a coffee addict, swear never to drink that stuff again. Save more of your income after taxes and feel the squeeze so that you realize how ridiculous your car spending is.

Recommended cars by income (tastes may differ)

Cars built in the 1990's and beyond are so much more reliable than those built prior.

If you are serious about improving your finances, consider buying a car with fewer options and fewer electronics to deal with. The more you have loaded in your car, the more maintenance headaches you will have in the future.

The choice for great wealth is yours

Treat the 1/10th rule of car buying like a game. You will be surprised to find how many different type of cars you can buy with 1/10th your income if you make over $25,000 a year.

If you want a $30,000 car, get motivated by the 1/10th rule to figure out a way to make $300,000 a year. One way is to start a side hustle to generate more income. I never thought when I started Financial Samurai in 2009 that I could leave the corporate world for good in 2012 and make more than I did as an Executive Director at an investment bank, but here I am.

If you can't get motivated, then fine. Just don't think you can afford much more. Think about your future and the future of your family. A car is simply there to take you reliably from point A to point B.

"The thrill of owning a new or new used car lasts for only several months, but the pain of paying the same car payment lasts for years."

If you're thinking about prestige and impressing others, don't be silly. Owning a nice property is way more impressive because at least you can potentially make some money from the asset!

One of the worst financial combos is owning a car that you purchased for much more than 1/10th your gross income and renting. You now have two of your largest expenses sucking money away from you every single month. Think about all the wealthy people you know, or the millionaires next door. Chances are high the majority of them own their homes and drive used cars that don't come close to 50 percent of their gross income.

If you want to achieve financial independence and not have to worry about material things stressing you out, follow my rule. If you want to detonate your finances and end up working longer than you want for the sake of a nicer ride, then go spend more than you can afford.

Sam Dogen is the founder of FinancialSamurai.com, a leading personal finance site established in 2009 that teaches people how to achieve financial freedom sooner, rather than later.

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A version of this article originally appeared on Financial Samurai.