In 2005, I finally got my first job out of undergrad, making $30k a year for a regional bank. At the time, I thought I was rich, having worked hourly, part-time positions before. I was driving the family hand-me-down car, a 1995 Ford Probe with 120k miles. First one brother drove it, then another, then me, then my sister, and finally back to me. The CD player didn’t work, the driver side door wouldn’t open so you had to crawl through the passenger side, and I had shorted out a speaker system in the back. After about two months working at the bank, I decided I wanted to buy a new car. I wanted a Jeep Liberty, and nothing could stop me from getting one, not even my lack of down payment or growing student loan payments. I walked into the dealership, test drove my Jeep and paid the employee rate. Financed at 8.55% over 72 months, it was mine.
Fast forward over 9 years, and I still drive that car. Sure, every year or so I have to do a large repair (brakes, fans, suspension work, etc.), the A/C doesn’t work very well, my antenna snapped off so I rarely get any radio reception, and I can’t turn the wheel to the far end of its normal range. Last weekend, R and I were on our way to meet some friends at a lake house to enjoy a relaxing weekend. Unfortunately, 2/3rds of the way there my car started overheating. We ended up having to spend the night at a motel, and carefully drive the car back in the morning with the A/C totally off and the windows down. I quickly had a decision to make: when is it time to get a new car? How would I pay for it? How much can I afford, or how much should I spend?
In doing some research, I decided to see what the personal finance people feel is appropriate. Dave Ramsey says 10%; so does this post from Financial Samurai. 10% seemed low to me. The article didn’t make sense, either. I started to question the “don’t spend more than 10% on the purchase price of the car” mentality. Let’s take it step by step.
First, I take issue with the notion that you should ONLY spend 10%, no matter what. FS talks about if you make $40k, you can only spend $4k on your car. If you make $400k, you should only spend $40k on a car. But does that make sense? If you’re making that much money, you’re likely already in a strong financial position, not living paycheck to paycheck or swamped with debt. You’re probably already maxing out your retirement accounts. If you’re in a strong position, and you enjoy nice cars, who’s to say you can’t spend more than that on a car?
Secondly, how feasible is this? According to the Bureau of Labor Statistics, the average annual salary in the U.S. is $46,440. Using the 10% rule, that means you shouldn’t go over $4,644 on a vehicle purchase. But what about everything else? Let’s look at some other factors. For my age group, the average monthly car insurance rate is $82 (assuming you have liability, comprehensive and collision on your policy) according to this article. Annually, that comes out to $992. The Energy Information Association estimates that gas accounts for 4% of pretax income. That’s a large chunk. Finally, the BLS also estimates that the average household spends 1.5% of its annual income on auto repairs. If we add this all up, it comes to $3,546.20. Assuming Dave Ramsey’s budget includes these categories within his Transportation heading, that leaves $1,097.8 to spend on the ACTUAL car. Good luck finding a car for that price.
Lastly, I take exception to some of Financial Samurai’s points about why you shouldn’t spend more than 10% on a car. Let’s go through these one by one:
1) Maintenance costs: We’ve got auto insurance, maintenance, parking tickets, and traffic tickets. Furthermore, 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.
This is true….for all vehicles. Whether you spend $3k on a 15 year old beater or buy a brand new BMW, you’ll pay auto insurance, maintenance, and possibly parking and traffic tickets. Insurance MAY be cheaper on a used vehicle, but you can guarantee that maintenance costs would be more expensive on that used car. And whether you buy a new car, or a new-to-you car, the thrill will wear off after a few months. If the same point applies to both sides of the decision, then those points are no longer valid.
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 over the past three years instead of paying for a car? Probably around $15,000-$30,000!
Again, this would apply to both. If I buy a used car in cash, I am forgoing the opportunity cost to invest that money. If you have good enough credit to score 0% financing, or close to it, then even a simple savings account would yield a positive return. Whether you spend $4k upfront or spread out money over several years, you’re still losing out on the opportunity to do something else with that money.
3) Stress. When you pay more than 1/10th your income for a car, you will become more stressed. The stress you feel from not wanting to park your car in a crowded lot is completely because you cannot afford 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.
This one is just silly. My Jeep is over 9 years old, has 136k miles and is full of dents and dings, and I STILL get stressed in a crowded parking lot. If I spent only a little bit of cash on a car, I would also feel stress from wondering if it would break down, if I got a raw deal on the beater or if it got stolen. Stress exists in life for a variety of reasons. Whether you spend 1/10th of your salary on a car, or finance a car, you’ll still experience stress. The simple act of driving is stressful!
4) Makes you want more. The nicer your car, the nicer your 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. Having nice things makes you want to have nice everything!
Another point I completely disagree with. So if you finance a car, you are helpless to not spend money elsewhere to live up to the image? If I “splurge” and finance a new Honda Civic, must I spend money on clothes and accessories to live up to that image of someone who can afford to buy a Civic in cash? Will I want people to see me coming out of The Olive Garden? No. This is just ridiculous. I can assure you that whether someone finances a car or follows this rule, their impulse spending control will determine this, not their car. Plenty of people are capable of buying a car, spending more than 10% of their salary and NOT racking up credit card bills because they bought that car.
5) Makes you feel stupid. Deep down, you know that if you can’t pay cash for your car and have money left over, 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?
Sigh. Buying a car that’s above 10% of your salary = you are dumb, no matter what.
Here’s my problem with his views on this: it ignores the utility a person can derive from their car, the enjoyment they could get, the peace of mind from having reliable transportation. Know what these things equal? Value. Value is not just a dollar figure; it’s why people enjoy vacations. The rest, relaxation, seeing things you never thought you would see. Spending more than 10% does not make you dumb, or force you to spend uncontrollably in other areas. Spending less than 10% does not remove maintenance/insurance/parking tickets/traffic tickets, does not remove stress.
Want to know the secret? Be smart about it. Think about what your financial priorities are and follow that plan. You know you should be socking away money for retirement, for an emergency fund and for other things. If you make $40k a year, have no savings and aren’t putting money into a retirement account, you likely cannot afford a new car. If you make $40k, have a handle on your monthly expenses, have a sizable down payment to avoid being underwater, and are putting away a decent amount towards savings, you may be able to afford something that’s more than $4k. For me, I make a decent salary, have no consumer debt and am paying down my student loans while saving a great deal every month. I’ll find a sensible car that meets my needs and does not put me anywhere close to financial ruin.