Reader Question: Continual Car Saving

by Kevin on February 13, 2008

I received an e-mail from a reader with a question. I told him I would answer on here to open up the discussion to anyone else that wanted to bring in some input. This post is rather long, but hopefully there are some advice that is useful to you.

I have been following your blog and I have a question about one particular item that I have not seen you discuss.

How do you and your wife prepare for major purchases that you know are unavoidable?

Obviously you have an emergency fund for things that come up that you do not expect. But what are you currently doing for the things that you do expect?

The main item in question for me is cars. I know that my vehicle will not last forever, and I know what my plan is for replacing them someday. But I am just curious what your plan for that is. I will share my plan. It is Dave Ramsey’s idea, but I think it is a good one. Basically you invest the equivalent of a car payment into a good mutual fund for 5 years.

After that first 5 years there is enough money in that fund to pay cash for a good slightly used car, plus enough money left in there that will continue to accrue enough interest that you will never have to put any more money in it. Meaning that every 5-7 years the fund will have earned enough interest to pay again for a good used car. The only modification I plan to make is to put the money I get from selling my current car back into the fund. I believe this will allow me to upgrade every 5-7 years as well.

All this is to ask:

  1. Do you think this is a good plan?
  2. Do you currently have a plan in place?
  3. And if you don’t think this is a good plan what would you recommend?

So, a lot to tackle here. Let’s break it down.

For expenses that are unknown, the reader is right. We have an emergency fund for unexpected costs (water heater exploding, flat tire, car/house insurance deductibles, etc.).

For anticipated expenses that are down the road, we try to budget it out as reasonably as possible. Are we currently saving for our next cars? No, but they are on the list. Here’s some examples:

  • Saving for a ‘new’ used car – we would like to get to the point that we are consistently saving for this, even if it were $100 per month. Every little bit counts. Saving a full car payment depends on what your idea of a car payment is.
  • Saving for new tires for our cars – I think it would be a bit overboard to save up a specific amount each month for new tires right when you buy a new pair. If our monthly cash flow is healthy, I may just eat the cost of tires in the month it happens. If not, we may spread the cost out over a couple of months. If I see the tires are wearing down and I can plan for it, I would share the cost over several months.

In regards to Dave Ramsey’s plan, this is how I understood it. Assume you have a car payment of $350. You pay off the car this month. This should leave you $350 next month to do as you please. Dave’s advice is to continue to save that amount every month, just like you had a constant car payment. When the time comes to sell your car, you’ll have enough cash on hand to purchase a new used one… and restart the cycle. That’s the plan I’ve heard.

As to the plan that was mentioned by the reader, I am a bit skeptical. Let’s run the math (link to Excel sheet I created). If you pay $350 per month to yourself and earn 0.67% growth per month after fees and taxes (8% per year / 12 months = 0.67%). Pay the $350 for 60 months, and you should have $25,888.35. Let’s take out $15,000 for a used car, leaving you with $10,888.35. (Of course, you would add the selling price of your previous car to that $15k as well, so you might not need the full $15k.) That principle is going to have to grow over the next five years to not only pay for the next used car, but also keep funding itself to buy the car after that. Running the math, the likelihood of that happening looks slim to none. It would work to buy the first and second car, though.

If you bump it out to seven years of payments and seven years between cars, the math is a lot more promising. It looks like you could pull it off. Really, in the end, if you have enough in an account that earns a consistent return, you would be able to estimate what your ‘income’ off of the fund would be. If that amount over your specific period of time is greater than the cost of a new used vehicle, then you’re golden.

However, you can only crunch numbers for so long before it starts getting really complex. You can’t factor in for issues like investment loss (or lower growth), inflation, taxes, or the value of the car you would sell. Well, you could, but it would be complex!

I would always be cautious in putting money into an account that I am going to need within a short time frame. I think five years is a relatively short period of time compared to retirement. Imagine putting your money into the mutual fund in 1999 and watching it lose a large amount of its value over the next few years. If you had to buy a car in 2001, you would be in some pain. If the money was in a more safe vehicle (bonds or a high yield savings account), I would be more comfortable, but then you are giving up possible investment growth (difference between what it could have grown and the yield on the account).

To answer the questions above:

  1. Do you think this is a good plan? – I think it can work. It might be a little too risky for my blood. I would prefer a savings account for liquidity purposes. As JD at GetRichSlowly likes to say, “Do what works for you.”
  2. Do you currently have a plan in place? – Actually, no. (Gasp!) Saving for a new car is on our savings snowball list (more on that later), but we are focusing on funding our NYC trip, emergency fund, MBA debt in deferral, and Roth IRAs currently.
  3. And if you don’t think this is a good plan what would you recommend? Again, do what works for you. I don’t think it is necessarily a bad plan. It really depends on the cost of the ‘new’ vehicle, how much your investments really return, and a ton of other factors. The bottom line is awareness is a big step forward in this arena. Simply knowing that a car is going to be need to be replaced ahead of time puts you a step ahead in the game.

{ 3 comments }

FranticWoman February 13, 2008 at 9:48 am

I am 40 and have never had a car payment in my life by using the “pay yourself a car payment, not the bank” rule.

It has worked fine. My last car I bought in 1998 for cash and put a $200 car payment each month for 10 years. I will probably have to spend $10-$12k on my next car and have plenty of savings for that. I kept a certain amt in liquid savings and the excess went to various accts (mutual funds, roth, etc).

Due to inflation, I’d probably increase my “car payment” after my next car. At the time of my last car purchase that was all I could afford if I had needed a loan.

I don’t know if your reader intends to trade in his cars rapidly or not. I buy my cars to drive into the ground. The last car I bought has been a mechanical dream so I had no desire to “upgrade” even though over the years it sure got ugly 🙂

I also find buying new cars foolish, even with a 0% loan. However, most people argue with me on this and how great having a new car and car payment are! woohoo for them.

Leigh February 13, 2008 at 10:12 pm

I tend to agree with you, Kevin. We save for our ‘new’ car in our credit union. It is safe, very liquid yet it earned well over 4% last year. We started saving 2 1/2 years prior to buying it so we needed something very safe. We were able to pay cash for our current vehicle and it feels great! I watch all the people at work driving their 08 vehs but having to head down to the credit union to pay their bill each month. I head down there ONLY to put money in! LOL!

JLiz February 20, 2008 at 4:44 pm

Since the reader mentioned Dave Ramsey, here is a link to a video on the DR site that discusses the concept in more detail.

http://www.daveramsey.com/etc/lms/drive_free/

It’s not quite like the reader describes: you have to keep making your payments to the fund for a number of years as you babystep your way up to better and better cars. The idea is:
– save your initial “payments” for a number of months,
– buy a used car for something like $6000 (which would probably be a car that’s at the slow end of its annual depreciation rate) using what you’ve saved plus whatever you get for selling your current car,
– keep making your payments to yourself,
– sell the $6000 car at the end of the year for a little less than what you bought it for (again, since it’s not depreciating at the same rate as a brand new or late model used car),
– buy a slightly nicer used car with the proceeds and some of your savings, keep making those payments, sell again, rinse, repeat.

After so many years of this (6 years – a typical car loan’s life), he says you will get to the point where you will have enough in the account to be able to buy a $20,000-ish car every so many years just on the interest that builds up. Then take that “car payment” and invest it.

The only beef I have is the size of the payment in the example: $475. With that much money going in each month, he says to sell every 10 months and jump up about $4k (what you’ve saved in that time) in what you’re paying for the next used car. If you’re saving $350 a month (a more realistic amount, at least for me), then the timelines change, or the quality of the cars will drop.

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