The Hidden Costs of Splurging on a New Car Too Soon: The 5% Rule Explained

Purchasing a new or expensive car when you're young can be a poor financial decision due to rapid depreciation and high associated costs.

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Often, the allure of a brand new, shiny car can be overwhelming, especially when you are young and starting to earn a substantial income. Who wouldn't love the new-car smell or the admiration of friends when you roll up in a sparkling, latest-model car? But here at CentsiBull, we advocate for financial wisdom, and there's more than meets the eye when it comes to buying a new or expensive car. Today, we will explore why splurging on an expensive car at a young age can be a poor financial decision and why keeping your car payments close to or below 5% of your income is the smart way to go.

The Allure and the Downfall of the New Car

A new car is not just a vehicle—it often represents freedom, status, and success. But it's essential to remember that cars are depreciating assets. The moment you drive your brand new car off the lot, it loses a significant portion of its value – as much as 20-30% in the first year alone, and up to 60% over the first five years.

Moreover, new and luxury cars often come with high insurance rates, costly repairs, and hefty maintenance bills. Young drivers, in particular, face higher insurance premiums due to their perceived risk. So, the sticker price you see at the dealership is only the beginning of the financial commitment you are making.

Opportunity Cost and the Power of Compound Interest

When you're young, time is on your side, especially when it comes to investing. The power of compound interest is at its greatest during your early earning years. If you're diverting a large chunk of your income into car payments, you're missing out on potential growth in your investment portfolio.

Let's say you decide to buy a less expensive car and manage to save $300 per month on car-related expenses as a result. If you were to invest that $300 every month for 30 years with an average return of 7%, you would accumulate over $370,000! This sizable sum could be used towards your retirement, purchasing a home, or even starting your own business. And yes, at that point you can maybe consider responsibly splurging on a nice car.  The high cost of a new car robs you of these opportunities.

The 5% Rule: A Golden Guideline

So how much should you realistically be spending on a car? A good rule of thumb is to keep your car payments — this includes your loan payment, insurance, and maintenance — as close to 5% of your after-tax income, if not lower, as possible. 

Why 5%? It's a figure that balances the need for reliable transportation with the rest of your financial goals. It allows enough room in your budget to cover your living expenses, pay off any debt, save, and invest for your future. It keeps your car from becoming a financial burden and allows you to continue building wealth.

The Advantages of Adhering to the 5% Rule

Adhering to the 5% rule has multiple benefits:

• Prevents Financial Stress: Keeping your car costs within 5% of your income can prevent financial stress. You'll have a much easier time managing your finances if you're not overburdened with hefty car payments.

• Enables Savings and Investments: This rule ensures that a sufficient part of your income is free to put towards savings, investments, or towards other financial goals. It optimizes the power of compound interest over time.

• Allows for Greater Financial Flexibility: If an emergency comes up or you decide to make a significant life change, you're in a much better position if a minimal percentage of your income is tied up in a car payment.

• Promotes Living within Your Means: By sticking to the 5% rule, you foster a mindset of living within your means and making sound purchasing decisions, not just for cars but for other aspects of life too.

How to Find the Right Car

While you certainly want to avoid purchasing a new car and facing the brunt of depreciation, you also don't want a clunker that ends up costing you more in the long term because of constant maintenance and repairs.  So when is the right time in a car's life to find the best value?  In general, you'll face the steepest losses from depreciation in the first 3 years following the purchase of a new car, so avoid cars in this range.  After 8-9 years, the depreciation curve begins to flatten out and become less meaningful when making your decision.  

The sweet spot likely falls within the 3-8 year old range for a used car to where you can find the best value relative to depreciation.  However, it's a good idea to do your research, as depreciation may vary by model (i.e. Toyota's and Honda's tend to hold their value well in the outer years).  

You'll also want to do your research on the true cost of ownership for every car, as the 5-10 years costs can vary dramatically based on the reliability and associated maintenance expenses.  Both Kelley Blue Book and Edmunds (among many other resources) publish 5-Year Trust Cost of Ownership breakdowns for most models.

Conclusion

While the allure of a brand new or expensive car can be tempting, especially when you're young, it's often not the wisest financial decision. Being smart about your car expenditure and adhering to the 5% rule can pay off enormously in the long run, helping you build wealth and financial security. Remember, financial wisdom isn't about denying yourself pleasures — it's about making choices today that your future self will benefit from in multiples.

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