Tuesday, August 16, 2011

Strategy for Paying for Cars

Jonathan Chevreau asked his readers whether he should keep his old car running or buying a new one, and the reader response was solidly in favour of keeping the old car. I tend to agree that it makes sense to keep a car as long as possible. However, the day must come when we have to let go and replace our cars. The question then is how to pay for the new car.

I think the answer is preparation. If you’ve got a good old car that is running well and not costing you too much money to keep in working order, then you should be able to save a couple of hundred dollars each month toward a new car. If you can’t afford to do this, then you really can’t afford your car.

The best way to pay for a car is in cash. For one thing, you’ll think twice about buying an expensive car if you’ve had to save up the money. When you do buy your car, you can immediately start saving for the next car. This will save thousands in interest payments.

For the majority of people who have fallen off this particular wagon, having an old car with no payments left on it gives them the opportunity to put the amount of the payments into a savings account that will later reduce the debt on the next car. For many people I’ve known, the single best thing they could do for their finances is get their car spending under control.

25 comments:

  1. The Blunt Bean CounterAugust 16, 2011 at 8:00 AM

    "For many people I’ve known, the single best thing they could do for their finances is get their car spending under control."

    Michael, right on. As an anal accountant I track my expenses on Quicken and the first week of January I print a summary from the prior year. The yearly expense that always causes me nausea is my auto expense.

    Also, from a tax perspective and the buy vs lease question, it is my opinion that buying makes the most sense when you plan to drive your purchased car essentially into the ground.

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  2. @Big Cajun Man: That can be an excellent option to save money. I don't know many people who have had a car and switch to the bus, but some do it.

    @Mark: I think your ability to track car expenses is a great benefit; my guess is that most people have little idea how much they spend on cars.

    Those who are able to write off some fraction of their car expenses may have to crunch the numbers, but I think for the bulk of people of modest means who pay for all car costs with after-tax dollars, the best approach is buying a car with cash (prefereably a used car).

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  3. Suppose you have $20k in cash. Instead of buying a car outright, you borrow on a HELOC at 4% to pay for the car. You invest the $20k and earn a 10% return. Each year you hold the position, you net a 6% return in which case you are making $1,200 per year. Interest outflow, $800, investment income, $2,000.

    The numbers work in any case where you have a positive spread between your investment return and the cost to service the debt.

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  4. @Ahmed: Yup. In theory you can earn mountains of money from nothing with leverage and good investment returns. I'd suggest reading what Buffett has had to say about leverage over the years. He writes his warnings better than I do.

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  5. @Michael

    This is not just about making money. It's about not tying up your capital.

    Also, look at the example I gave. Assuming the car lasts 15 years, the total return summed up means a return of $18,000 (i.e., 15 years x $1,200/year). The car was practically free.

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  6. @Ahmed: In the late 90's a couple of financial advisors tried to sell me the same leveraged dream you speak of. I'm glad I didn't take their advice. After the tech crash I would have been left with about enough money for a tin cup and some pencils.

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  7. @Michael,

    In my original post, I said "invest", not "speculate". Tech stocks were all speculation to anyone who could read an annual report.

    If you knew absolutely nothing about investing and used my method and only bought a diversified portfolio of utility stocks, returning say 8%, my example still works. Even if the BOC raised interest rates to a neutral level and HELOCs went to 6%. Worst case outcome is you break even.

    Again, HELOC interest at 6% and investment income at 8%. Spread is 2%. This is $400 on the $20k. And your capital is not tied up in car.

    I don't see a downside.

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  8. @Ahmed. Sigh. I can only assume that you're just having fun with this, but I'll play along a little longer. I didn't say that the advisors wanted to put me into tech stocks. They actually recommended some stock mutual funds that were essentially closet indexers with high MERs. But that matters little. Even "a diversified portfolio of utility stocks" would have been kicked in the teeth and would have generated margin calls.

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  9. @Michael,

    If you read my original and subsequent posts, I said use a HELOC, not margin debt. Hence, no margin calls.

    Also, there is a natural hedge here. If the stocks I mentioned fall in value say due to a recession (utility stocks wouldn't fall far), the BOC would be lowering interest rates and HELOC rates would trend lower. And if HELOC rates rose because of an improving economy, your portfolio returns would increase for the same reason, an improving economy.

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  10. @Ahmed: Not to worry. You can use employment income to pay interest on money borrowed for investments gone bad whether you use a HELOC or margin.

    I've had a few bosses who would have loved your reasoning. They liked employees heavily in debt because these employees really need their jobs and are more compliant.

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  11. @Michael,

    How exactly does a diversified portfolio of utility stocks go bad?

    I think the problem is that while I'm speaking in specifics, your speaking in generalities. While your points may be valid in general, you should be addressing the examples I've given.

    HELOC at 4%, utility stocks earning 8%. Spread is 4%. Show me the flaw in my argument.

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  12. That is my post above. I hit the button before I got my name in.

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  13. @Ahmed: I bet that over 90% of the time there would be nothing wrong with your argument and this strategy would work perfectly.

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  14. @Michael,

    Your article is rather timely for the discussions going on around my house.

    We own both our cars, have for many years now, and it's soon time to take the plunge and get a new vehicle. It's going to be very annoying to make a car payment after not doing so for many years, but such is life.

    Hopefully we can make a sizeable down payment and ease the debt burden.

    Mark

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  15. @Ahmed: You're being naive. Banks are not stupid. If there's a way to earn 8% risk-free, why in the world would they be loaning money to you instead at 4%?

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  16. @Mark: I highly recommend the lemon-aid books by Phil Edmonston on new and used cars. There is no better source for unbiased information about cars in Canada. These books are available in most libraries.

    @Patrick: I agree. There is no free lunch. Nassim Taleb has made a career out of explaining that seemingly impossible events happen with regularity. It makes little sense to be highly leveraged and exposed to events that seem impossible but are, in fact, alarmingly probable.

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  17. Don't forget about the effects of inflation.

    If you save your money in an online savings account and get 2%, and you have a 33% marginal income tax rate, then after tax you are earning 1.33%. But if inflation is 3%, then after inflation you are earning a negative real rate of return:
    (1.0133/1.03 - 1) = -1.62%

    If you borrow money at 4%, then after you inflation you really only paying interest at:
    (1.04/1.03 - 1) = 0.97%

    So what is better, earning -1.62%, or paying 0.97%?

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  18. @Anonymous: Your line of reasoning requires some assumptions. The first is that current conditions will remain the same over the course of a loan. We don't know when interest rates will rise. They certainly can't drop much more. The second is that the car buyer who frees up capital by borrowing won't either just spend the available money or invest it in risky assets that lose their value at the same time the car buyer loses his or her job. The story remains the same: leverage increases risk. Each person needs to gauge his or her risk tolerance with an understanding that current conditions can change.

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  19. Exactly what I've doing last 3 years....$300 every month into a car savings account. Auto transfers, set it and forget it.

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  20. @Ben: I'm glad to hear it. I get far too many people who think it's just impossible to save up and pay cash for a car.

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  21. When I have bought cars in the past I used money from my investment account and a line of credit. I like the LOC because you can pay it off quickly, as you get money. I also do not believe in having debts.

    I must admit it has been a while since I bought a car. My current car is a 1995 Hyundai Accent that I bought in 1996. As usual, I paid for it with money from my Trading Account and my LOC. I paid off the LOC within 6 months.

    I needed a car at that point because I had a cottage. Since I sold my cottage in 2004, I do not use my car much, about twice a week. I have not sold it as it does not cost me much. It runs well and it has no rust. I live in downtown Toronto, so I can walk most places or just hop on the TTC.

    Also, referring to other post, I do not think that any stock portfolio is without risk, even one of utility companies. I have never regretted buying having a car and no car loans.

    Susan

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  22. @Susan: It sounds like you've kept your car costs to sensible levels. I think if some people knew how much their cars cost them they would make different choices.

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  23. This is a topic at my house too. We were putting 80% of 'windfall' money (tax returns, bonuses, money made from a home business above the amount that was expected, etc) towards our next vehicle purchase. As our family is growing, we expected to need a vehicle capable of handling an infant seat, a toddler seat, and a booster in the next couple of years (if all goes according to plan).

    We were well on our way, at about 30% of our expected cost after the first year, and with almost two years to go before the expected purchase time, we felt comfortable with our plan.

    People talk about inflation as a reason not to put money in a savings account, but in actuality, the amount lost due to inflation (at the current rates) are far less than what is added to the account over the short term that I am comfortable with the plan. To each his/her own.

    Anyway, all was well until my position was downsized and I spent two months unemployed, and start my new job at the beginning of Sept.

    The challenge now is that my new job is in an area of town poorly serviced by transit (I carpooled or took transit to my previous job, which had a taxable benefit of paid transit fees).

    So my choices are

    A: Continue taking transit, which costs $80/month (ish), and I spend 2 hours a day on the bus (one hour each way), or

    B: Buy a second car two years earlier than planned and somehow absorb the operating costs/car payment (if applicable) into my budget. Getting a second car would reduce my commuting time to
    40 minutes (20 min each way).

    Now, with all choices, it all comes down to the individuals values. Is a new car with full warranty and a monthly payment coupled with steep depreciation more important than a monthly savings amount but unknown potential repair bills, or the lower costs of public transit, but spending almost an hour and a half more each day away from family?

    I think these are the real questions to be answered when it comes time for the car purchase question. Once the values are ironed out and prioritized (such as the difference in values about leverage mentioned above), then them appropriate strategy can be implemented.

    And for the record, though I have my core values, I am still sorting their priorities, and balancing them with my spouse's priority values. Once we can agree on those, then we can begin the debate about which vehicles (brands/models) to consider.

    I think buying a house together would be easier than a car, as it is at least expected to increase in value, but that's a topic for another day.

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  24. @AKA: It's too bad that your car savings turned into emergency savings, but I guess you're better off than if you had just spent extra money and had no savings at all when your job disappeared. Before plunging into purchasing a second car, you probably should consider what would happen if your new job disappeared.

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