Shopping for a car can be an exciting process, here is a list of things to take into consideration when looking to purchase a vehicle.
Obviously most young people and newlyweds starting out cannot afford to have the purchasing capabilities of a millionaire, but it is good to know the habits that will help you reach that destination.
80% of millionaires pay cash for their cars, and the average car purchased by a millionaire is 4 years old with 41,000 miles.
With that in mind, the reality for most people is that early on they need to replace their first car, which was probably not great to begin with, so they need to finance a decent car that will give them a reliable means of transportation. Car loans are not ideal, and should be avoided if possible, because if done wrong they can set you back financially for years.
Let's look at how you can responsibly finance a vehicle if paying cash is not an option yet.
What is my price range?
How much car can I afford? This should be the first question we ask ourselves when planning our budget for a new vehicle. The most expensive consumption item a person will buy in their life is housing, and the second most expensive item is their car. Getting these two categories right finically will put you in an extremely advantageous spot, but getting these categories wrong will help you fall back down the mountain.
We recommend 10% of your household income should be allocated to transportation expenses.
This includes:
The important thing to remember is that we want to be conservative with our vehicle purchase, stretching ourselves thin because we bought too much car will only lead to unwanted levels of stress. It is easy to walk around a dealership and have our eyes be bigger than our wallets, but remember the goal is to actually be rich, not just look rich. If all of our income is going to lifestyle purchases, then we will never achieve financial independence.
Own your car, don't let your car own you.
What kind of loan should I get?
If you are going to get a car loan, we recommend at minimum the 20/3/10 rule.
The interest rate comes after these three categories in terms of priority. The rate should be fixed, and as low as possible contingent upon the first three criteria being met. Not meeting one of these criteria in order to secure a lower interest rate will cost you more money over the course of the loan, placing it last on the tier list of priorities.
Down Payment
We recommend a down payment of at least 20% because it accomplishes two goals:
Loan Term
We recommend 3 year terms because at the rate that vehicles depreciate, you do not want to have negative equity or be underwater with the car in the event that you need to sell it. The largest trap with vehicle financing is the focus on monthly payments.
The first question that dealers ask when you are shopping is "How much can you afford per month?". This is because they want to back into the highest monthly payment, at the longest possible term (typically 72 months), so that you spend thousands of dollars extra over those extra 2-3 years. It is easy to see a $10K price difference between two cars up front, it is much harder to see that extra $10K spread out over a few years because your monthly payment is the same.
People who finance vehicles for 5-6 years often find themselves with negative equity because the deprecation rate exceeds the repayment rate. The only way to get out from under this is to pay extra so the loan is paid off quicker, but if you could afford to do this, why not just have the term shorter so that you pay less in interest and less for the car overall? This is not like a 15-year fixed rate mortgage vs a 30-year fixed rate mortgage because real estate appreciates over time, whereas vehicles depreciate in value over time, but this is a common misconception.
Monthly Payment
We recommend 10% of your household income should be allocated to transportation expenses so that all other expense categories do not suffer as a result of overspending on a vehicle.
10% has been found to be a sweet-spot for reliability, responsibility, and happiness. This amount is not so small that you are buying a beater that breaks down once a week, but not so large that it is financially irresponsible and leads to increased stress. It is also enough that will you will be happy with the purchase and enjoy the amenities that come with nice car.
How do I know if I'm buying a high-quality car?
Researching the best vehicle for you is an important step in the car buying process, you do not want to be the person who complains to everyone about how many problems your car has and you wish you bought something else.
The following websites can help you find what car is best for you, which ones are high-quality, and what problems you can expect to encounter during ownership.
Will a nicer car make me more happy?
It is important for us to be aware of the relationship between car consumption and happiness. The fact is luxury car owners are not happier than frugal car owners long-term, but when we are test driving a BMW, that Toyota we were considering does not look as attractive now.
A 2015 study by Kozaryn and colleagues found that luxury cars do not contribute much happiness above what an inexpensive car would. We talk a lot about diminishing marginal utility (DMU) which is, each additional item consumed brings less happiness, which happens to be a core reason for this result.
To illustrate DMU let's use steak as an example, say the first steak increases our happiness by 1, the second by 0.5, the third by 0.25, and so on, at some point we will get full and sick of steak, leading to an experience of negative utility or unhappiness.
It is the same with cars, there is a greater happiness gap between people without a car and people with an inexpensive car, than between people with an inexpensive car and people with a luxury car. While buying a luxury car spikes happiness higher than buying an inexpensive car, it shortly returns to the same baseline of happiness because at the end of the day it is providing the same utility as the inexpensive car. The average luxury car owner is happy with their purchase for an additional 2 weeks relative to the average inexpensive car owner. Considering the price difference between these cars, I would expect much more ROI on my happiness than just 2 weeks.
The primary negative factor that helps offset the immediate pleasure of a luxury car is that they cost more money and, hence, more time.
Second, the more a person pays for a car the more they worry about it being stolen, damaged etc, which act like anchors that are tied to our happiness.
Third is that the opportunity cost of buying a luxury car is not worth the investment. We can buy a Lexus for $50K or a Camry for $25K; the difference is $25k — enough to buy 10 vacations at $2.5K each. Which do you think would make you happier, a Lexus, or a Camry + 10 vacations?
The fourth reason is that most families have more than one car, and each person over their lifetime will have multiple cars themselves, so a "new" car is not actually a new experience, just a variation of a previous experience.
Lastly, vehicles are depreciating assets, which decrease in value over time. Knowing that the item we just spent good money on will decrease over time until it is worthless, combined with the fact that we constantly see more luxurious alternatives every time we drive our vehicle, leads to a mindset that prioritizes reliability in achieving its purpose, rather than the comfort by which it achieves that purpose.
We love luxury cars, and are not against them if someone can afford it, but the reality is many people overextend themselves on car purchases in order to satisfy the desire for a nicer car.
The goal should be to increase your income, so that your budget for transportation increases, which will increase your level of car without also increasing your level of stress.
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