Car Loans

Last week, I discussed debt and described the difference between asset backed debt and unsecured debt. I used the analogy of debt being like digging a hole in your back yard. In short, asset backed debt means that the dirt you used to dig the hole is right beside the hole. If something bad happens, you can fill the hole back in with the asset. Think mortgages. You buy the house with debt, but the house is an asset that you could sell to pay off the loan if need be.

Unsecured debt is when you go into debt, or dig a hole, but the dirt is trucked away. If you need to fill in the hole, or pay off the debt, there is no dirt in sight. Think credit card purchases for a fancy meal. The meal is gone. You can’t sell the meal to pay off the debt. You are going to need to go and find more dirt somewhere else to pay off that loan! 

This week, I want to talk about car loans - one of the biggest monthly expenses for many households. 

When you dig a hole and take out a car loan, the same dirt principle applies. Is your asset bigger than the hole you are digging? If you had to, would you be able to sell your vehicle and fill the hole back in? In other words, would you be able to pay off the loan by selling the car? Cars are tricky. Cars are depreciating assets. They are still assets, but the pile of dirt beside your hole keeps getting smaller and smaller, often faster than you are paying back the loan. 

First, if you do not have a savings account that is equal to 5 months of expenses (Your New Savings Zero), then I do not recommend car loans.. Auto loans have notoriously been a financial trap that have taken up way too much room in people’s budgets. Having a $500 per month auto payment significantly slows your progress towards financial freedom.

If you don’t have a vehicle, then purchase a cheap one. If you have zero cash and feel you must get a loan, get a very small loan for the time being. In the future, you can get a better car. But don’t rob yourself of a sturdy financial foundation because you wanted a sweet ride. If your savings account is fully funded, then auto loans are permissible, but certainly never a requirement or even a recommendation. 

When getting a car loan, you should always pay 25% of your vehicle in either a trade or in cash. Cars depreciate, and they often depreciate significantly right as you drive them off of the lot. We don’t want to have an asset that is smaller than the hole we are digging, so we always recommend 25% down. 

If you decide you’d like an auto loan, you should never take on an auto loan that is bigger than your New Savings Zero. If you have $25,000 in your savings account, then the loan should be no more than $25,000. Even though the vehicle is an asset and you are paying the loan off over a shorter period of time, cars can depreciate quickly or just stop working and be totally valueless. Our savings account provides the extra dirt, so in case of absolute emergencies, we still have cash to pay off our loan and fill in our hole. 

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Zach Santmier is the owner of Trumble Agency, Inc. and the author of the personal financial course, Increase. He focuses on helping families escape paycheck to paycheck living so they can freely pursue their ideal future.