Cars are one of the poorest investments you can make. After 5 years, the average automobile will depreciate by over 60%, so keep that in mind when you budget for a car.
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Since the average price of a new car is roughly $35k, this means that the average new car buyer will lose $21k over 5 years. When you consider the opportunity cost, they would have had over $90k had the $35k been invested over 10 years!
Why People Spend Too Much on a Car
The median income in the United States is only $31k, and the average price of a new car is $35k. Therefore, people are spending more on cars than they make in a year!
How does this happen? Car companies show you the monthly price you’ll pay instead of the total price. Monthly payments for a $35k car is around $800. $800 per month is a lot easier to digest than $35k. We fall for the same trick with cell phone plans and rent.
Emotions play a part as well. Once you’re invested in a car, you can easily justify paying a few hundred dollars more per month for all the bells and whistles you want. Unfortunately that few hundred dollars per month results in in thousands of dollars in the purchase price of a car. The same mindset that makes you house poor can make you car poor as well.
Following the 1/10th Rule
The 1/10th rule is simple – spend no more than 10% of your gross annual income on a car. If you make $40k per year, you should spend no more than $4k on a new car. With this mindset, you’ll be nowhere near the average purchase price of $35k!
The monthly payment for a $4k car is only $91, which is a lot more bearable than the $800 per month needed for the average $35k car. Following this gives you a lot more money to set aside for your hierarchy of savings.
Other Costs to Consider
A car costs more than the monthly payments. There are maintenance fees, insurance, and stress. Expensive cars such as BMW or Porsche cost a lot more in maintenance compared to affordable cars such as a Honda. Insurance is also tied to the value of the car, you’ll save a killing insuring a $4k car compared to a $35k car. Make sure to factor those ancillary costs when you budget for a car.
Stress is important to consider as well. You’ll be worried sick if you own a car that’s worth more than your salary. Every time you park or drive it, you’ll be concerned that something may happen. If the car is only a fraction of your salary, you’ll spend a lot less time worrying about something occurring.
If You Already Spent Too Much on a Car
Don’t worry if you already pulled the trigger on too much car. The important thing is to acknowledge and fix it. Your options are to either sell the car, or own the car until it becomes worth 1/10th of your salary.
Sell the Car
If you own too much car, you need to sell it as quickly as possible. Not only is the car making you poor, it is also rapidly depreciating in value.
The sooner you sell the car, the sooner you right-size your finances. You should only delay to make sure you negotiate a decent price.
Own the Car As Long as Possible
Another option could be to own the car until the value becomes 1/10th of your salary. If the transaction costs of selling your car and buying another don’t pencil out, and the car is already close to 1/10th your salary, patience could be a virtue.
Budget for a Car – The Bottom Line
Cars one of the major investments people make, and it also happens to have the poorest returns. Cars depreciate 60% over 5 years on average – whereas the S&P 500 returns 10% per year. The difference really adds up over several years, so budget for a car appropriately.
By following the 1/10th rule, you’ll have an affordable mode of transportation with a ton of financial flexibility. You’ll be able to maximize your savings and continue building your net worth.