Buying a new car – Wake the fck up!

The impact of buying a new car versus a second-hand one will have a tremendous financial impact on both your own and your family’s finances. We are talking about hundreds of thousands of dollars…

In this post I will just show you three different ways of looking upon buying a new car (transportation is the second biggest expense for the average US family). I will also touch upon the impact it will have on the life of the purchaser, both short- and long-term.

There are always different alternatives and situations to choose from and I can of course not go through every eventuality. Therefore I will have to make some assumptions and I will try to be clear about them.

In this post I will refer to the twins, Joe the Joyer and Frederic the Free. Joe tends to always spend all his money and rarely has any savings left. He tends to worry frequently about money but still never learns and spends like there is no tomorrow.

Frederic on the other hand is free from financial worry as he is living by his means, taking well care of his money and has made them his servant (they are working for him and not only vice versa).

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The purchase alternatives (assumptions)

Let’s start with the fact that the average car bought in the US in January 2018 cost 36,200 USD and that will be our starting point. Although as cars in the US are much cheaper than in many other countries, we will use 40,000 USD in our examples. We will look at the financial impact of purchasing a car using different alternatives but will NOT take into account any running nor any fixed costs associated with owning a car as those numbers can vary significantly but I would guess at least 300 USD per month on average….

1. Buying a new car by cash payment

Joe the Joyer obviously has no possibility of buying a new car for cash as he never seems to have any!

Frederic the Free of course has the cash as he has been planning to buy a new car for some time and has been saving. Therefore the money is in his account. Frederic realizes that he has a few alternatives to choose from as his financials are very strong. He can either buy cash, take out a car loan or even increase his small mortgage on his house to finance the car.

Buying the car outright would mean 40,000 USD out of his account right now but that would not be a problem as he had saved for it and would still have very strong finances. Fredric of course wants to make the wisest financial decision so he will not make up his mind until he has gone through all his alternatives and decided which one will be more favorable to him and his family.

2. Buying a new car by taking out a car loan

Joe the Joyer is not sure how he is going to handle this as he doesn’t have the 10% down payment the dealer wants (since no savings…). Not to worry. When Joe really wants something he usually becomes creative and now he really wants this car to impress the new girl he is dating. So he applies for and gets a new (his ninth) credit card and maxes that out so that he has the 4,000 USD he needs to pay the dealer. Of course he has no idea what the interest on that card is, nor how he is ever going to be able to pay it back… Well, he will worry later on, now he just wants to get his hands on that new car!

Frederic the Free has the 4,000 USD and can easily get the loan but as he has the cash, he is not sure if that is what he wants to do as he knows the loan will be quite expensive…

The dealer is not very flexible and both of them get the same terms and an interest of 5% (which by historical terms is very low but it can always increase as this is a floating rate…).

Frederic will have no problem paying the 680 USD per month but on the other hand, he is not that keen on paying the dealer almost 5,000 USD in interest over the five year period! However, if history repeats itself, Frederic will be able to generate a higher return by investing his money (his historical average is 10% so paying 5% would still be ok). He would also have more financial flexibility as he would keep 36,000 USD invested which would be at his disposal at any time (and of course at that current market value).

Joe, has no idea how he is going to find 680 USD per month to pay for the loan as he has never managed to save any money, but a new car is a new car and he will find a way later. He therefore proceeds with buying the car! What he forgets is that his newly acquired credit card debt of 4,000 USD is running at 20% interest (high because of his poor finances) and with no amortization. This is another 67 USD per month in infinity (as he doesn’t amortize) but he is currently happily unaware.

The car itself will over a ten year period cost Joe 45,000 USD plus the interest on his credit card of 8,000 USD, a grand total of 53,000 USD. At that point in time I estimate the value of the car having decreased to 10,000 USD. If he sells the car for 10,000 USD he can pay off his 4,000 USD credit card debt (although unlikely based on his track-record). If he does, he has paid 53,000 USD in total for the car and has 6,000 USD to his name after 10 years of owning that car which means a cost of 47,000 USD. Again, no running nor any fixed costs associated with owning a car has been included as that number can vary significantly but I would guess at least 300 USD per month on average…

3. Buying a new car by increasing the mortgage

Joe the Joyer is renting a flat and paying rent to his landlord (who is making passive income out of Joe) so he has no mortgage as he doesn’t “own” his own property. This means that Joe won’t have the possibility of increasing his mortgage to pay for a new car.

Frederic the Free on the other hand owns his house with a small mortgage on it and has a very good relationship with his bank as he is very updated and informed about his finances. Because of his level of knowledge, the bank knows they have to give him the best service and lowest cost on everything, else Frederic will simply take his business to another bank. Because of his strong finances, he frequently receives calls and invitations from other banks as they want him to transfer his money to them…

Frederic gives his private banker a call and asks about the possibility to increase his mortgage with 40,000 USD. Of course there is no problem and the suggested rate is in line with his mortgage which is currently running at a 2,5% variable rate.

If we do similar comparison as before and Frederic assumes he can generate 10% in return on his investments and pay 2,5% to the bank (no amortization as his loan is so small), after ten years it would be worth approximately 80,000 USD! He basically keeps his money invested, making 10% return per year but has to pay 2,5% in interest on his increased mortgage which means he is making 7,5% return per year on his 40,000 USD which he leaves in his investment account.

Ten years later, Frederic could then pay the bank the 40,000 USD, whilst still having 40,000 USD in his investment account and own a car valued at 10,000 USD! Basically, his investments paid for the car and more!

This alternative is of course much more appealing to Frederic since the interest cost is half compared to the car loan but he still keeps the flexibility as he still has his 40,000 USD invested in his name and hence available at any time (again at the current market valuation).

Frederic wants to become even more Financially Free!

After some contemplation Frederic has still not decided what he wants to do as he knows that buying a brand new car is one of the worst and most expensive purchases one can ever make! On average one third of the value of the car disappears once you drive it out from the dealer! Hmm, there must be some other alternatives that would still let him buy a nice car without committing financial suicide…

He knows he is by no means any financial genius but he has learned from some of the best in the market and stayed invested for the long-term. His historical return is in line with the overall US stock market (S&P 500), which means his investments have generated an average return of around 10% per year.

The initial primary alternative for Frederic (as he is always investing for the long run which to him is +15 years) was buying a new car by borrowing the money from his bank (increasing his mortgage). By doing so, he would have a new car and after ten years, still have 40,000 USD more compared to if he were to pay for it with his cash (yes, he believes that over the long-term, his return will be similar and he has both the capacity and the willingness to take the risk).

He reads up a bit more about the craziness of buying a brand new car and realizes that he prioritizes his and his family’s financial freedom far more than having a brand new car, knowing how stupid it is to buy one. It would be great if there is a way for him to keep the money in his pocket, his financial flexibility and security whilst still getting another car for the family as they do need to change…

Frederic then starts looking at second-hand cars and realizes that it is a much more appealing alternative and the market for second-hand cars is huge. A lot of people buy new cars so there is plenty of them on the second-hand market. All he has to do is finding a good quality car (reliable, low maintenance, low tax and insurance) which is 5-10 years old and with low mileage and he would most likely save a ton of money! If he finds one and buys it for around 10,000 USD, he can keep the difference of 30,000 USD invested in the stock market and still own a car which most people will think is new (as few people can really tell the difference nowadays).

If he were to purchase the new car then he would have a car worth 10,000 USD after ten years (same as for Joe). If he instead kept the 30,000 USD invested and if he managed to get the same return over the next decade he would have:

The graph shows that if Frederic the Free manages to get the same return, his 30,000 USD would have grown to almost 80,000 USD! The car would already have been paid for in cash and he would have 80,000 USD in his investment account, how cool is that!

As you know, Frederic had been saving in order to have this 40,000 USD to use for buying a new car for cash. Instead he managed to save 30,000 USD from this “new car” over five years (410 USD per month with an average return of 10%). Putting this money aside has now become a habit of his so he doesn’t even think about the 410 USD automatically going to his investment account every year. Therefore, he will of course keep on saving that same amount every year (so every 5 years, he will have saved 30,000 USD for a potential new car purchase). In the calculation below I have excluded these consistent monthly savings and just show what his initial investment of 30,000 USD would be worth after 30 years and with 10% return per year and it is half a million dollars!! If we also include his continuous monthly savings we would have to add another 300,000 USD to the below amount…

The difference between Joe and Frederic

Joe is no longer so joyful as ten years have passed and he only has 6,000 USD to his name after using 53,000 USD to purchase and finance this car. The cost of the purchase is totaling 47,000 USD. He realizes it would have felt a lot better having that full amount in his account and potentially even a larger amount, had he just taken the time to learn a bit about money and investing. The joy of driving a new car lasted for a few weeks but the headaches of the monthly payments lasted for five years and to be honest, he has not really managed to pay it off yet. To make the payments for the car, he had to get into even more debt, meaning his future is not very bright, nor does he have any cash and he is constantly worrying about money…

Frederic on the other hand, has been very happy with his choice of buying a second-hand car and to be honest, if you are not a proper car enthusiast you probably can’t tell the difference between a brand new car and a car which is 5-10 years old but which has been taken excellent care of.

So what is the difference between these two? Nothing really as they are twins! Just looking at them, you could not tell the difference. The dramatic difference appears when you understand how differently they have chosen to use (or not to use) their brains. One of them has decided to take financial control over his life, meaning never having to worry about money, whilst the other one never “could find the time”. He was sooo busy with his life, that one of the things he should have prioritized the most, never got any attention and now he and his family are paying the price of a catastrophic financial situation (yes, he did manage to find a partner). They can’t get a mortgage as it will take years if not decades to pay off all of their debt. Their relationship with money is so bad, they can’t even talk about money without arguing and you can guess the impact this is having on their kids and their kids’ relationship with money…

Frederic is happy and his family is happy, since over this period they have 80,000 USD in their investment account compared to Joe, who has spent 47,000 USD, a difference of 127,000 USD between the two!!

I will let you be judge of which twin is having more quality of life, peace of mind and joy in their life.

Is this for real??

This is not a real life example of two twins but it could have been. This is how many of us handle money and car purchases. Of course I have made many assumptions and simplified a lot of things but all of it is completely realistic. You don’t have to agree and that is totally ok. The only thing I wanted to show is that most things can be done in many different ways and with different consequences. By making insightful decisions, we can be more certain about the impact of our choices in life and hence have a great and positive impact on how we live. That to me is life on our terms.

I could have shown many more examples, included many more costs, argued in different ways but that was not my intention. My intention was only to in a clear way show that the decisions we make and how we implement those can have significant impact on the quality of our lives, both in the short-term and in the long-term. It might give you a nice feeling to drive a certain car (for a couple of weeks) and maybe you can even impress your neighbors by buying a new car (even though you actually don’t own it since you have borrowed the money to buy it!). But if it jeopardizes your quality of life because you constantly worry and argue about money, the relationship with your partner will probably suffer as well, is it really worth it?

In the end it is your life, your terms and you are free to choose how you live and what you do. I just hope this post gave you a different perspective of how the rich people (or the ones prioritizing financial freedom) think and potentially act even though my examples of buying a new car are simplified. I can’t give you any financial advise but there are always different ways of acting in different situations. Why not prioritize your family’s future over that new car and keeping up with the Joneses? Joe will have to live with his choice and so will Frederic and I know whose shoes I would want to be in…