How to buy the car of your dreams.
Simple Finance Weekly Newsletter (Week 12)
Buying a car can be a luxury, a dream or a necessity for some. Lets go over how to make “The car buying experience” a happy one.
With the advent of Ola and Uber, car sales seem to have gone down, millennials are adopting minimalistic lifestyles, they prefer not to accumulate possessions, they prefer to rather rent and pay for the services.
But you may have to face certain problems like waiting for the cab on hot sunny days, surge pricing during office hours, if you go for uber/ola pooling, it may drastically increase your travel time. As they say Time is money, for office goers or someone on strict schedule and budget, you may not always be able to depend on cabs.
So if you decide to buy a new car for yourself, you have to account for not just the cost of the car, but also the service, fuel, insurance, parking, tolls etc. Remember, ex showroom cost and on road cost of the car are two different things, the following discussion will be based on the final cost of the car, which can be a step beyond on road price if you plan to buy accessories, music system or have a shinny coating on your new car (including a treat that you will owe all your friends and relatives, Ha Ha)
Lets see some financial thumb rules which will help you finalise a price range.
Firstly you have to understand that a car is a depreciating asset and to get maximum value out of your purchase, you have to be ready to use the same car for 10 years or more.
The first thumb rule is-Do not spend more than half of your annual household income on the car. So if your annual household income is 10 Lakhs then the final cost of your purchase should not exceed 5 lakhs.
Second thumb rule to follow while taking a loan is Rule of 20/4/10 which says,
Make down payment of 20% of the cost of the car, more the merrier, helps in lowering the loan term and EMI. There are lenders who finance 100% of on road cost of the car, but I will suggest to plan, take your time and save up as it is a big purchase.
Do not go for a loan duration of more than 4 years
Keep the EMI of the car loan under 10% of your take home salary, Do not let the total EMIs of all loans together, be more than 30-35%.
If you have saved money specifically for buying a car and the spent amount is not going to have any impact on your other more crucial goals of retirement, kid’s education etc then you can consider buying the car outright.
Sometimes it makes sense to take a loan even if you have a capacity to make outright payment for your purchase, but only when you are going to retain the car for 5 years or more and rate of interest on your car loan is 6-7%.
You can invest/keep invested, the amount that would have been an outright payment for your car purchase in mutual fund with appropriate asset allocation.
Suppose you are taking a loan of 10,00,000/- @7.5% for 5 years, your EMI will be 20,038/- total amount paid inclusive of interest will be 12,02,280/-
In effect you are paying 2,02,280/- more over the period of 5 years.
To earn 2,02,280/- in a mutual fund over a period of 5 years, you need to earn 4% compounded annually for 5 years on 10 lakhs, which through proper asset allocation is possible. Any return above 4% is a win. It may so happen that you end up getting a 12% rate of return on 10 Lakhs, you will end up with 5.73 Lakhs (plus 10L initial amount) at the end of 4 years, much more than the interest outgo on the loan.
Opportunity cost- based on above thumb rules if you come to a conclusion that you can buy a car of 10 lakhs, but you do not want to miss the extra bells and whistles and you decide to spend 2 Lakhs more for the purchase.
Here If you keep the 2 Lakhs invested for the period of 4 years and able to earn 10% per annum, the final amount will be 2.9 lakhs. So you miss the opportunity of earning 90,000 on 2 lakhs.
While if you end up taking loan for that 2 lakhs for 4 years at 7%, you have to pay 30,000 more.
So its important to keep in mind the opportunity cost of money while exceeding your budget, as this lost opportunity may have an impact on other goals.
Finally, just because you are eligible for a bigger loan does not mean you should stretch your budget and end up paying an EMI which becomes unaffordable. As seen in the article on Home loan, not being able to pay EMIs of a loan has a great impact on credit score and future credit worthiness.
Home and car are the first things that we plan as soon as we start earning our first salary. But there are other things that need your attention. (Refer Home loan article)
Finally do not fall prey to Diderot effect
Denis Diderot was a French philosopher, who had written one of the most comprehensive encyclopedias of the time. His daughter was about to get married but he did not have much money for dowry. Empress of Russia, bought Diderot’s library for around $ 50,000 in today’s terms. He decides to buy a robe for himself, immediately he started noticing that all his other possessions appeared pale in comparison, and ended up buying many more things to match the beauty of the robe.
Key take away here is that once you buy something, it becomes a part of your identity and we start accumulating other stuff to match with own perceived identity. Same thing can happen with new car, latest iPhone ect.
Morgan Housel has written in his book Psychology of money that when you buy a new car, you expect respect and admiration from people but when others see you, they see your possessions as their aspirations, they do not ponder on how successful, rich you are. They start day dreaming about your possessions and how cool they would look in your car. In any case, spending money is not the way to earn respect and admiration. Even if you get it, it will not be from people who you actually want to be respected by.
If you already have bought a car, you can still implement above thumb rules,
Start with paying higher EMI to finish off the loan in 4 years, even if it means exceeding the 35% of your salary in paying EMI for a short while.
Make up a mindset that you are going to use the car for 10 years,
You may even think of selling and downgrading your car if you had exceeded the first rule related to annual household income by 4 times or more and car loan EMI alone is more than 20% of your take home salary.
Real wealth is not in buying, but in not buying.
Hope you liked reading this weeks article, Stay tuned for Simple Finance.