I recently stumbled upon a slideshow presentation on Dave Ramsey’s website title Drive Free, Retire Rich. I think the slideshow should be called Drive Debt-Free, Retire Rich, but that’s besides the point. If you’re anything like a normal American, you most definitely have a car. And if you’re anything like the average American, you probably have or have had, a car payment. According to the National Automobile Dealers Association, the average price of a new car sold in the United States is $28,400. According to Edmunds, a new car loses 15-25% of its value per year. The depreciation will largely depend on the make, model and condition of the car, but for this math, we’ll use 20% as the average. Whatever number you choose to use, everybody knows that cars lose a large amount of their value in the first few years of their life. With all of this depreciation, what usually happens? Most people will find that that they’re “underwater” on their loan. This seems to have a terrible stigma when it comes to homes. People worry about being “underwater”, which means they owe more on their home than it’s worth. This isn’t necessarily a bad thing if the value of your home is going to rise and you don’t intend to move and sell in the near future. However, for a car, this seems terrible. The car isn’t going up in value, and you most likely intend to sell it at some point in the next few years. So what’s the solution? I think this slideshow presents a good alternative.
For the math, let’s assume you decide to buy the average $28,400 car. Let’s also assume your current car is worth about $5,400 at trade in, so you need a loan for $23,000. If you were to purchase this car today, and you had good credit, you could get a 4-year, 5% car loan. With this loan, your monthly payment would be $530/month!! To put that in perspective…I currently pay $600 per month in rent! RENT. But that’s for another time. So…back to this scenario. After 4 years, you’ve paid $23,000 in principal, $2,400 in interest, plus the $5,400 trade in. So in total, you would have paid $30,800 for this car (ignoring any time-value of money factors). Now, after 4 years, based on 20% annual depreciation, your car would be worth about $11k. Most people would then go a year without a car payment, and then decide they’re ready to upgrade again. You trade in the car for $9k and you start all over with a big car loan. This is how people get stuck paying a car loan for their entire life. This isn’t good, fiscally or emotionally. Cars drive better when they are carrying around all that debt in the trunk.
But there’s an alternative. What if you never took out another car loan again? How would that work. As someone who’s interested in pursuing such an approach, I’ll use my current numbers to paint this picture. This is my current car. It’s a 1999 Ford Escort. Don’t worry, I know exactly what you’re thinking. “Hey Will, you drive such a nice car! I wish I could save up enough money to buy such a fine automobile.” It’s true, I can’t deny it. I bet you can imagine how impressed everyone at work is when I roll up in this beauty…right… But back to the numbers. So, kbb.com tells me that my car is currently worth about $2k, which I believe is a fair assessment for my car since it runs great. So, the way the Drive Debt-Free plan works is this: Instead of buying a new car and paying a car loan, I’m going to put that money in a savings account each and every month. Instead of paying a loan, I’m going to be saving and paying cash for a car! Oh my! Imagine not having a car payment… So, the first step is to figure out a figure for how much you’d like a car to cost you each money. Paying $530/mo as I calculated above is just much too rich for my blood. I don’t need anything fancy, but I’d definitely like to upgrade from where I currently am. I personally think that $250 is a reasonable monthly figure for now. So, if I put aside $250/mo for a year, I’d have $3,000 saved up. In a year, I could likely get at least $1.8k for my car, assuming it’s still running fine. At the low end, depreciation really slows down because a working car is simply a working car. So, if I sell my car in a year, I’d be able to buy a car on Craigslist for $4,800. Now, my ideal car price is approximately $8k-$10k, so as long as my car is working great in a year, I’d bypass the upgrade and save for another year. So in two years, saving $250/mo, I’d have $7,800. That will allow me to upgrade from my 1999 Ford Escort, to a 2009 Ford Focus. (I can get a 2007 Focus today for that price, so I assume in 2 years I can get a 2009 for that price.) Once I’ve reached a car within my goal range, I can then cut back my savings so that it keeps up with depreciation. I could cut back the savings to approximately $200/mo. From then on, each year or two, I can upgrade. And the whole time, I’m paying $200 or so a month.
Now, for many of you, the number will be higher. If you want a car for the family, you may want a small SUV. The plan still works the same way. You save the money you’d be paying on a loan, and just continue to upgrade. You pay cash the whole way. Once you’ve reached a car in the price range you want to stay, you only need to save enough to keep up with depreciation. I think this is what I want to do for my upcoming car upgrade, so this is now going to be my tentative plan. I better go open up a new Ally bank account for my savings.