This is one of the most asked questions I get from clients and friends alike. I always preface my thoughts on this subject as being outside a normal guru’s opinion and that they may not like what I have to say.
So, for you dear Life Leader, I say the same to you.
I believe everyone who is old enough to work and own a vehicle should always have a vehicle payment. Unless, of course you are independently wealthy and have cash flow in abundance.
Hear me out! The ultimate goal is to get your vehicle paid off and to purchase your next one with cash, correct? But how do you get there when you are living paycheck to paycheck?
I realize the argument of “you have more cash flow when you have no vehicle payment” but all too often I see people getting antsy with their vehicle as time goes on. Let’s take a look at a few psychological spending personalities to see the impact of having more cash flow and no vehicle payment.
Personality type A – If you are like me and love a new car every three to five years. It is common to get really antsy with your vehicle as time moves forward. Usually, resulting in a new purchase and a new payment anyway. Add the fact most of the interest paid on an auto loan is paid in the front three years of your loan resulting in less overall savings against cost of funds. I realize there are many things you can do differently in the purchase of a new vehicle but that is another blog post.
Personality type B – Once the vehicle is paid off you increase your lifestyle using the old payment money and can never fit a new vehicle payment into your budget when one becomes necessary. Vehicles age, they die, and they have to be replaced eventually. Don’t forget to take into consideration the unexpected maintenance costs of an older vehicle, which people tend to put on credit cards in the time of need. My mother has this personality type. She will drive her vehicle into the ground, which is not a bad thing at all, but the thought of adding a new car payment at today’s purchase prices makes her cringe with fear of having enough money to live since she is retired and is on a fixed income.
Personality type C – Paying off your vehicle with what little savings you have, to add cash flow to your current financial situation and then getting into a bind because there still isn’t enough money to cover those unexpected events that inevitably show up. So, you borrow against the vehicle again at a higher interest rate than the original loan. Now, you have no savings and you have a new vehicle payment in the budget where things are already so tight you can barely see light.
Introspection time: Take a look at your vehicle pattern over your lifetime of owning vehicles. Are you fitting into one of the three patterns above or is your pattern different? I would love to hear what you came up with, if you wouldn’t mind sharing in the comments below or you can email them to me at firstname.lastname@example.org.
Once you have identified your pattern let’s take a look at other things to consider from a strategic perspective.
1. What exactly is your point in paying off your vehicle loan? Understanding your WHY will help you to be clear on whether this decision is part of your perpetual pattern, which you identified above, or if you are ready to slow down and create an overall strategy for paying it off.
- Did you receive a chunk of money and are thinking about putting it towards the vehicle loan? Check your savings and debt strategy first. Those are better options over the vehicle, unless you are debt free and have the appropriate amount of savings already in place. Then ask yourself, am I working my vehicle plan? (continue with blog post to learn more) If no, put it toward your vehicle plan. If yes, maybe funding your dream is a better idea.
- Is your car payment too high to manage on a monthly basis? Maybe trading down is a better idea.
- Is it because you keep hearing the gurus or your family say debt is bad! Get rid of it as soon as possible, and use any means possible to do it. There is more to consider than just getting rid of debt. Especially when it comes to your vehicle.
2. Do you have an Emergency Fund? This is for emergency medical needs only. I always recommend a separate account of about $2,500 in it at all times. It can be an HSA account, or an account created on your own. This fund should always be the first fund you create and work towards. If you do not have this yet, then maybe that nice little lump sum you just received should go here first.
3. Do you have a minimum of 6 months to a year of savings in your LIVING FUND? How long can you survive if something unspeakable happens to your job? All the guru’s tout the importance of having at least six months of expenses in your savings for emergencies. I agree and see you a year! I call this the LIFE FUND because it also works when you are wanting a life change. It allows you to step into your life’s purpose, take advantage of opportunities, or change careers if you so choose to do so.
4. Cost of funds: Do you have a consumer debt? If you have other consumer debt and are perpetually using credit cards to enjoy your life, you are truly throwing money right out the window. Look at your current cards and list each balance due and interest rate you are currently paying. Average the rate out. Did the average come close to the national average of 19+%? Now, what is the interest rate on your vehicle? You can google auto loan calculators to see how much interest you are paying on the current balance and term of your vehicle and then use it for your credit card balances over that same amount of time remaining. What is your shock factor? Where do you think the best place for that lump sum will be served? Credit cards and other consumer spending debt costs more than your auto debt. BUT WAIT – DON’T JUMP HERE. There is still more to consider. Do you have an overall debt strategy in place to knock these out first?
5. Is my vehicle the best use of this lump sum money? If you do not have your Emergency and Life Funds yet and you do not have a Budget for Life, with a Debt payoff strategy in place, then there is probably a better use for these funds then paying off your vehicle.
Let’s dive into why I believe everyone should always have a vehicle payment and why paying off your current vehicle may not be the wisest choice in this moment.
Let’s say you have your Emergency Fund saved and you have a strategy in place to reach your six-month Life Fund goal. Now you are feeling antsy about having liquid money in the bank, while still paying a vehicle payment. Introspection moment: Hhhmmmmmm? Why do I feel so drawn to empty my savings to pay off my vehicle? What is it about having liquid money available to me, that feels so uncomfortable?
- Your belief system may go to “the money in my savings is not working for me, aka making me money, and I am paying for the money I borrowed for my vehicle.” I should take the money from my savings and pay off my vehicle! Whose voice is that? How do you feel and act differently when you are tight for money rather than abundant in it?
- It may go to “I am uncomfortable and anxious when I have liquid money available to me. I will spend it if I don’t make proper use of it immediately.” Where does your worth fit into this belief? Where does your fear of not being allowed to have it or fear of it being taken from you come from?
- It may be something completely different. See if you can identify the impulse for yourself.
Why this concept is WRONG!
If something unforeseen happens, you are screwed all the way around and it takes longer to regain those funds, then it does to continue making the payment you are already used to making. Let’s look closer.
Scenario: Let’s say you bought a new Honda Accord in October 2016 for $35K + tax, tag, title, fees. You borrowed $38K at a rate of 3.4% and a term of 72 months. Your monthly payment is $585.00, and you have 36 months remaining until payoff. You would still owe $20K over the next 36 months until the vehicle is paid off. You save $1,064 over three years in interest, $580, $360, and $130 respectively, and lose at least four months’ worth of expense savings.
- Let’s say you have $50 a month going into your Life Fund and you do not have the full six months in there yet but you do have more than $20K. You are thinking you will take it from here and save some interest over time and you will have almost $600 more dollars a month to work with in your budget.
- Here is the problem with this strategy. You just lost four months’ worth of living expenses if your expenses are sitting at around $5k a month and you lose your job. Not to mention at $50 a month ($600 a year) it will take you over 33 years to get your $20K back into the savings account. What happens when it is time to buy a new vehicle and you have successfully increased your lifestyle to use up the extra monthly money? You are now adjusted to a new lifestyle and have no room in your budget to finance another vehicle in the class you are accustom to.
- Let’s take a different route. Let’s say you take the $20K from your Life Fund and decide to put the entire payment back into the account on a monthly bases (which I would recommend if you have already done this move), you have still four months of living expenses from the account and it will take two and a half years to replenish it. How much longer do you need to reach your minimum six months’ worth of Life Fund at the payment? Your vehicle is now five years old and you would need another four and a half years at this same $600 a month to purchase the not so same $35K vehicle with a trade in, that is now almost ten years old.
- Either way you are risking security for short term gain and minimal savings each year on the loan interest, because you are already on the downward interest collection cycle. You are also no closer to purchasing your next vehicle with cash. How long are you committed to holding on to this vehicle before creating another loan? Because as the vehicle ages, so does the trade-in-value.
So, what would I recommend instead? I would recommend giving yourself time and patients to accomplish all at the same time.
1. Fund your Emergency Fund as soon as you can and with any ethical means possible.
2. Continue funding your Life Fund until you reach your goal. As long as you have a plan and are working your plan you are fine.
3. Make sure you are on a debt slashing strategy. Get rid of your consumer debt first.
4. Once that debt is gone, roll your payment into your vehicle loan. Do not add extra payments to this loan until all other consumer debt is gone. The extra is better utilized there because of the cost of funds differentiation between consumer interest charges and your vehicle interest charges.
- If the remaining term has already expired, then commit to holding onto your vehicle for a period of time. You can hold firm so you can prepare for your next purchase.
5. Determine when you plan to buy your next vehicle and how much you are wanting to pay for it. Remember the buying patterns we identified earlier in the blog post. Use an online auto calculator to determine what the monthly payment for this purchase will be.
6. Determine if you are wanting to save for the full purchase price or just a percentage for a down payment.
- If you are wanting to pay the next vehicle in full with cash, then shift the entire payment amount you used to crash your debt and pay off your vehicle with your new Vehicle Fund account, until you get to your desired purchase goal. You can then use the auto purchase calculator to determine what your normal payment with interest would have been and then use that figure to pay yourself back for the amount used. Basically, creating a “Borrow from yourself” scenario. Bankrate.com has a great calculator. Just google Auto Loan Payment calculator.
- If you are wanting to save a down payment amount instead of the full purchase price, then shift the entire debt slashing payment into your new Vehicle Fund until you meet your goal. Once your goal is met and you are ready to buy, use an online auto calculator to determine what a payment would be if you were to finance the full amount. Take this payment and subtract what you are actually paying per month on the lower borrowed amount and pay yourself the difference into your Vehicle Fund for the next purchase.
7. Perpetuate the Vehicle Fund. If you never give up on a car payment you will always have money to purchase your next vehicle at either a lower monthly payment or in full using cash. You are just borrowing it from and paying interest to yourself instead of a lender. If you want to upgrade your next vehicle than adjust your savings figure by the expected payment on the purchase price. Don’t forget to add in Taxes, Tags, and Title.
My hope for you, is to see the importance of all things taken into consideration before paying off an auto loan. It may take a few purchase cycles to get to the point of paying cash for your vehicle, but it certainly is possible if you always have a vehicle payment.
Dive into your beliefs around this topic. Journal about them and then shift them. You can do things differently if you choose and commit to doing so.
Commitment, Dedication, and Grace to yourself through this process!