Car Loans
Last week, I discussed debt and described the difference between asset-backed debt and unsecured debt. I used the analogy of debt being like digging a hole in your backyard. In short, asset-backed debt means that the dirt you used to dig the hole is right beside the hole. If something bad happens, you can fill the hole back in with the asset. Think mortgages. You buy the house with debt, but it's an asset you could sell to pay off the loan if need be.
Unsecured debt is when you go into debt, or dig a hole, but the dirt is trucked away. If you need to fill in the hole, or pay off the debt, there is no dirt in sight. Think credit card purchases for a fancy meal. The meal is gone. You can’t sell the meal to pay off the debt. You are going to need to go and find more dirt somewhere else to pay off that loan!
This week, I want to talk about car loans, one of the biggest monthly expenses for many households.
When you dig a hole and take out a car loan, the same dirt principle applies. Is your asset bigger than the hole you are digging? If you had to, would you be able to sell your vehicle and fill the hole? In other words, would you be able to pay off the loan by selling the car? Cars are tricky. Cars are depreciating assets. They are still assets, but the pile of dirt beside your hole keeps getting smaller and smaller, often faster than you are paying back the loan.
First, if you do not have a savings account equal to 5 months of expenses (Your New Savings Zero), I do not recommend car loans. Auto loans have notoriously been a financial trap that has taken up way too much room in people’s budgets. Having a $ 500-per-month auto payment significantly slows your progress towards financial freedom.
If you don’t have a vehicle, then purchase a cheap one. If you have no cash and feel you must take out a loan, get a very small one for the time being. In the future, you can get a better car. But don’t rob yourself of a solid financial foundation just to get a sweet ride. If your savings account is fully funded, then auto loans are permissible, but certainly never a requirement or even a recommendation.
When getting a car loan, you should always pay 25% of the vehicle's price either as a trade-in or in cash. Cars depreciate, and they often depreciate significantly right as you drive them off the lot. We don’t want an asset smaller than the hole we are digging, so we always recommend 25% down.
If you decide you’d like an auto loan, you should never take on an auto loan that is bigger than your New Savings Zero. If you have $25,000 in your savings account, then the loan should be no more than $25,000. Even though the vehicle is an asset and you are paying off the loan over a shorter period, cars can depreciate quickly or just stop working, becoming totally valueless. Our savings account provides the extra cushion, so in absolute emergencies, we still have cash to pay off our loan and fill the hole.
Once you understand the dirt and the hole, you can start looking at debt differently. This week, we’re applying it to car loans. Next week, we’ll tackle the big one: mortgages.
To read all these steps and hear stories about how they work in real life, you can get your copy of INCREASE from The Wildwood Bookstore downtown Hastings or online on Amazon. If you choose to shop local at Wildwood, you’ll receive a copy of my children’s book, The Treehouse Dream, for free as a thank you!
Thank you in advance for purchasing a copy of INCREASE. Every purchase will help further this message of stewardship to our community and beyond.
Zach Santmier is the owner of Trumble Agency, Inc. and the author of the personal financial course, Increase. He focuses on helping families escape paycheck to paycheck living so they can freely pursue their ideal future.
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