The world’s simplest financial plan – don’t buy stuff you can’t afford

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Nick Foy, CFP®

Last month, Marketwatch ran a story detailing people who take out a loan to pay for their vacation. Yes, it really is just as bad an idea as you’d think.

It turns out companies like Affirm are willing to lend people money for just about anything, sort of like a credit card. Of course, that money doesn’t come cheap: The interest rates range from 10-30%, sort of like a credit card.

Reading that story reminded me of this skit from circa 2006 SNL, wherein an expert shares the holy grail of personal finance: Don’t buy stuff you can’t afford.

It seems few are taking his advice. I read this article in Forbes which showed that for the first time, the amount financed on the average vehicle has gone over $30,000, and the average monthly loan is $503.

What that tells me is that the average auto owner has at least an additional $503 per month in free cash flow that is swallowed up financing a depreciating asset. What’s difficult for me to grasp is how people have $500 in extra money each month, but can’t seem to figure out how to pay cash for a car. As Ben Carlson noted on his blog, SUVs might really be ruining retirement.

The mistake most people make is that when their car is paid off, they suddenly stop putting money toward a new vehicle. Then, when it comes time to purchase a car, they take on whatever debt is necessary to get whatever ride they want with whatever new features they can’t live without.

Instead, keep saving the monthly payment even after your car is paid off. Then, you’ll have the cash to purchase a new car outright. There are two main benefits to this methodology:

    1. Paying cash might mean you actually pay less, although not necessarily because you’ll get a better deal. It’s much harder to write a $50,000 check than it is to have a monthly payment for a few hundred dollars more every month. Setting a lower cap for a car price means you’ll be less likely to overspend.
    2. You’ll never pay any interest. Instead, earn interest on your own savings.

Take a look at this example of a client who has $12,000 saved up and is putting in $250 per month into a portfolio of 50% stocks and 50% bonds. Within 8 years, he’ll probably have enough saved to pay for a $40,000 car. At that point, he may or may not want to spend that much on a car, but the money will likely be available when the time comes.

2018.8.10 Blog post imageSource: Betterment

So, even if the average American seems to be able to afford to spend $503 per month to finance a depreciating asset, why would they?

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