Your car payment is a major obstacle to financial freedom

I should live in a bubble. Because I don’t know anyone in my circle who owns a car worth more than 1/10th of his annual gross income.

• My father drives a 28 year old car that’s probably worth $500 and his government pension is at least 100 times that.

• I drive an 11 year old car worth $15,000 and my passive income is over 10x that.

• My friend drives a 10-year-old Tesla Model S that probably costs $16,000, but he makes over $5 million a year.

• A neighbor recently paid off his house and celebrated by buying a three-year-old Honda Civic. He is 42 years old and already semi-retired.

I came up with the 1/10th rule for car buying 15 years ago to help people achieve financial freedom sooner. Since then thousands of people have followed this standard rule, but millions have not.

If you had invested $60,000 in the S&P 500 in 2012, you would have about $405,000 today. But if you used that $60,000 to buy a 5 Series BMW, it would be worth less than $9,000 today. Yet people still insist on buying cars for ridiculous amounts of money when they are guaranteed to incur depreciation and ongoing maintenance expenses.

The car is the number one personal finance killer for most Americans. Therefore, your car payment is also the main obstacle to your financial freedom.

Paying off your car kills the investment

When you have a car payment, that money goes toward paying off a depreciating asset rather than investing it in a potentially appreciating asset. Car payments also become a distraction. This is another financial account that requires you to stay on top of your investments rather than just letting them slip.

I found this informative video on Twitter that highlights how a delinquent car payment can hold you back financially. Watch and listen:

This example is at home because my wife wants to be a full-time preschool or kindergarten teacher. So far, she has worked as a substitute teacher for four days this past month at $24 an hour. If she works 40 hours a week, 50 weeks a year, she will earn $48,000 per year. This is on top of the online school she is currently taking.

The woman in this video is a top-tier kindergarten teacher who makes $7,500 per month or $90,000 per year. Congratulations to her, especially if she doesn’t live in an expensive city like San Francisco, LA, Seattle or New York. Plus, I also love how she’s spending $251 a month on a gym membership and personal trainer. Exercise is important for a better life.

However, with a $1,548 monthly car payment on his Mercedes-Benz G Wagon, he doesn’t have much left over each month. In fact, she ends up with negative $124, which she borrowed from a friend.

I used to own a G-Wagon myself

It’s funny, because when I was 25 I foolishly bought a G Wagon in 2002 for $75,000. I recently received a raise to Associate with a base salary of $80,000 (over $55,000) and a guaranteed bonus coming from Goldman Sachs in NYC to Credit Suisse in San Francisco. As a naive young man, I decided to blow a ton of money on a car I didn’t need.

I thought it was a steal because a year ago G500s were selling for $150,000 from a dealership in Santa Fe, New Mexico. That dealership had exclusive import rights, which Mercedes bought. I got rid of my G Wagon after only a year when I decided to buy a condo. That thing was too long to fit in the garage. After all, I took a $17,000 bath on it.

It was actually that experience that led me to think about the 1/10th rule for car buying. I remember when I bought the car, I saw the lady selling the car raising her hands happily and giving a high five to the manager. I didn’t want anyone else to go through the same financial stupidity I went through.

There’s nothing wrong with a $9,000 car instead

The teachers at the school are the best. They have the most important business in the world and are therefore underpaid. But today G Wagons are worth between $150,000 and $200,000, which is 167% to 220% of his annual salary. This is a far cry from my recommendation of spending 10% of your salary on a car.

Kindergarteners won’t give you more gold stars because you came in the G wagon. In fact, when parents see their child’s teacher drive into the parking lot in a $150,000 SUV they may start asking some uncomfortable questions.

For this teacher earning $90,000, a $9,000 second-hand vehicle would do just fine. There are lots of models to choose from.

X Factor: Working Spouse

What consoles me about this situation is that this kindergarten teacher has a spouse who paid her gas bill. And given that I believe people are generally smart and rational over the long run, it stands to reason that his spouse probably makes enough money that she feels safe purchasing a $150,000 vehicle with a $1,548 monthly car payment.

Based on my 1/10th rule, their household income should be between $1.5 and $2 million per year. So it’s possible that her husband earns more than $1.41 million per year, which puts him in the top 0.1% of earners. If he does that, great.

Even if they completely ignore my 1/10th rule and spend about 20% of their household income on the purchase price of the car (1/5th), they’re still making a combined $750,000 to $1 million. Not bad as a top 1% income earner.

I refuse to believe that with all the free financial education, this family would knowingly ruin their finances and force themselves to work forever just to afford luxury expenses. And again, it would be illogical to make a social media video about it.

Investing $150,000 today at an 8% annual return yields $323,850 after 10 years. That’s a nice chunk of change!

Make rational decisions and you will be fine financially

At the beginning of this article I was surprised by his car payment. But thinking logically, this teacher and her spouse would probably be fine. He has friends who will blow him up if he lacks them. Her husband pays for her gas and extra care.

Ultimately I am sure she will stand on her feet. Because if things get tight, or she decides she wants to teach soon, she’ll logically sell the car and reduce her expenses. Until then, she would love to drive to school in a car worth over $150,000 and enjoy every attraction that comes her way. At this point, those benefits far outweigh the costs for him. And this is absolutely logical. you do you.

However, there is one thing I want to pay attention to, and that is that his house to car ratio is completely bad. One of the cool traps of renting is greater monthly cash flow, which makes it attractive to spend on things like a fancy car. That’s exactly what I did for the first three years after college. As a car enthusiast, I bought a Volvo 850 GLT, BMW 5.40, BMW M3 and G-Wagon. This is easier to do when you do not have a mortgage.

If she and her husband really want to improve their odds at financial independence, they should become neutral on real estate by owning their primary residence. After that, reduce the home-to-car ratio to 30 or less. Otherwise it’s work forever until death, which sounds dramatic but is just math.

Reader Questions and Suggestions

Readers, why do some people make massive car payments on an asset they know will only decrease in value? Do you think car payments are the most common barrier to financial freedom? Why not just buy a cheap second hand car and invest the difference? No one is stopping you in any way. Just know the tradeoffs.

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’m into dollar cost averaging. money saving commercial real estate Right now because the valuation is low compared to the stock. With four years of underbuilding due to high interest rates, I expect rental and pricing pressure to increase in the coming years.