I must live in a bubble. Because in my area, I don’t know anyone who has a car worth more than 1/10th of their gross annual income.
- My dad drives a 28 year old car worth maybe $500 and he has a government pension worth at least 100 times that.
- I drive an 11 year old car worth maybe $15,000 and mine passive income it is more than 10 times more.
- My friend drives a 10 year old Tesla Model S worth maybe $16,000 but makes over $5 million a year.
- A neighbor just paid off his house and celebrated by buying a three-year-old Honda Civic. He is 42 years old and now semi-retired.
I came out with The 1/10 rule for car buying over 15 years ago to help people achieve financial freedom faster. Thousands have followed this standard rule since then, but millions more have not.
If you had invested $60,000 in 2012 in the S&P 500, you would have about $405,000 today. But if you used that $60,000 to buy a BMW 5 Series, it would be worth less than $9,000 today. Yet people still insist on buying cars for absurd amounts while they are guaranteed to depreciate and rack up ongoing maintenance costs.
A car is the number one personal finance killer for most Americans. Therefore, your car payment is also the main obstacle you have to financial freedom.
Your car payment collects investments
When you have a car payment, that money is being absorbed into paying off a depreciating asset instead of investing in a potentially appreciating asset. The car payment also becomes a distraction. It’s another financial account you need to stay on top of, rather than staying on top of your investments.
I found this insightful video on Twitter that highlights how a car payment can set you back financially. Watch and listen:
This example hits home because my wife is looking to become a full-time preschool or kindergarten teacher. So far, she has been working as a substitute teacher for $24 an hour for four days over the past month. If she works 40 hours a week, 50 weeks a year, she will earn $48,000 a year. This is on top of the online school she is currently attending.
The woman in this video is a high-level kindergarten teacher who makes $7,500 a month, or $90,000 a year. Kudos to her, especially if she doesn’t live in an expensive city like San Francisco, LA, Seattle, or New York. Also, I love how she’s spending $251 a month on a gym membership and a personal trainer. Exercise is crucial to a better life.
However, with a monthly payment of $1,548 on her Mercedes Benz G Wagon, she doesn’t have much left over each month. In fact, she ends up with $124 in the negative, which she borrows from a friend.
Used to own a G-Wagon myself
It’s funny because when I was 25 I bought a 2002 G Wagon for $75,000. I had just received a raise to Associate with a base salary of $80,000 (up from $55,000) and a guaranteed bonus from coming to Credit Suisse in San Francisco from Goldman Sachs in NYC. As a naive young man, I decided to throw a ton of money into a car I didn’t need.
I thought it was a steal since the G500s sold for $150,000 from a dealer in Santa Fe, New Mexico a year ago. That dealership had exclusive import rights, which Mercedes bought. After only a year I got rid of my G Wagon once decided to buy an apartment. The thing was too tall to fit in the garage. After all, I made a $17,000 bath on it.
It was actually that experience that led me to come up with the 1/10 rule for car buying. I remember seeing the car saleswoman raising her arms with joy and her manager when I bought the car. I didn’t want anyone else to go through the same financial crap I had just gone through myself.
Nothing wrong with a $9,000 car
The school teachers are the best. They have the most important profession in the world and therefore are underpaid. But G Wagons cost between $150,000 and $200,000 today, which is 167% to 220% of her annual salary. This is a far cry from my recommendation to spend 10% of your salary on a car.
Kindergarteners won’t give you more gold stars because you showed up in a G Wagon. In fact, their parents may start asking some uncomfortable questions when they see their child’s teacher pulling into the parking lot in a $150,000 SUV.
A $9,000 used vehicle would work well for this teacher making $90,000. There are many models to choose from.
The X Factor: The Working Husband
What comforts me about this situation is that this kindergarten teacher has a wife who paid her gas bill. And given that I believe people are generally smart and rational In the long run, it stands to reason that her husband will likely earn enough money that she would feel safe buying a $150,000 vehicle with a monthly payment of $1,548.
Based on my 1/10 rule, their household income should be somewhere between $1.5 and $2 million per year. So it’s possible that her husband is paid more than $1.41 million a year, which puts her in this 0.1% of winners. So awesome if you do.
Even if they completely ignore my 1/10 rule and spend roughly 20% of their household income on the purchase price of a car (1/5), they will likely make $750,000 to $1 million combined. Not bad as a the top 1% income earner..
I refuse to believe that with all the free financial education out there, this family would deliberately torpedo their finances and condemn themselves to forever work just for it finance luxury expenses. And then, making a social media video about it would be illogical.
Investing $150,000 today at an 8% annual return leads to $323,850 in 10 years. That’s a good chunk of change!
Make rational decisions and you will be fine financially
At the beginning of this article I was surprised by her car payment. But thinking about it logically, this teacher and her husband will probably be fine. She has friends who will bathe her when she runs away. She has a husband who covers her gas and extras.
Ultimately, I’m confident she’ll get back on her feet. Because if things get tight, or she decides she wants to get out of teaching sooner, she’ll logically sell the car and cut her expenses. Until then, she’ll enjoy driving to school in a $150,000 car and soaking up every bit of attention that comes her way. At this point, those benefits outweigh the costs for him. And this is completely rational. You do you.
However, there is one thing I want to talk about, and that is that house-car ratio is completely out of the way. One of the quiet pitfalls of leasing is having more monthly cash flow, which makes it tempting to splurge on things like a fancy car. That’s exactly what I did my first three years of college. I bought a Volvo 850 GLT, BMW 5.40, BMW M3 and a G-Wagon as car fanatic. Easy to do when you don’t have a mortgage staring you down.
If she and her husband really want to improve their chances of financial independence, they should be neutral about real estate by own their main residence. After that, get your home-to-car ratio to 30 or below. Otherwise it’s work forever to death, which sounds dramatic, but it’s just math.
Questions and suggestions for readers
Readers, why do some people take massive car payments for an asset they know will only decrease in value? Do you think car payments are the most common roadblock to financial independence? Why not just buy a cheaper second-hand car and invest the difference? No one is stopping you in any way. Just know the trade-offs.
Instead of buying an expensive car with a large car payment, invest that money in the S&P 500, bonds and real estate. Ten years later you’ll be glad you did. Personally I am dollar cost averaging Fundraising ads real estate now because valuations are low compared to stocks. With four years of low construction due to high interest rates, I expect rent and price pressure to increase in the coming years.
Fundrise is a long-time sponsor of Financial Samurai and Financial Samurai is a six-figure investor in Fundrise products. I am looking to diversify and earn more passive income from real estate, given that managing rental properties is a PITA.
