Whenever I write an article about buying cars for cash, paying off a house early, putting money away for investing, or retiring a millionaire, I always get a few responses about how it is not possible for most people on standard incomes to do these things. What many people who have the “normal” habits of taking out car loans, running up credit card balances, or buying houses with payments beyond 25% of their budgets don’t realize is that it is the act of staying out of debt that allows the few of us who pay cash for cars, home repairs, and vacations to do these things. We have more cash because we don’t spend so much money on interest. To understand this, let’s look at the effect of loans on your cashflow.
Most people, when they first get on their own and start their first job, run down to the car lot and buy a shiny new car with a six-year loan and payments of maybe $450 per month. When that car gets to be four or five years old, they go back to the dealer, trade in the car for $6,000 or so which they put towards a new car and roll the remainder of their original loan into the new one, again with a payment of $450 or $500 per month. They continue this their whole lives and as a result, always have a car payment. For a family with a couple of cars, the payments can easily be $1000 or more per month, or $12,000 per year.
Instead of buying a new car and then trading it in after five years, be on the other side of the trade. For $5000-$8,000 you can buy a quality 5-6 year-old used car from a private owner. The car will have 80,000-100,000 miles on it, but most cars today can go 200,000 to 300,000 before any serious problems start to occur. You might have a couple of repairs each year that cost $500-$1000, but that is just a couple of car payments. Save the difference and you’ll have enough money to pay cash for the next used cars in four years plus another $36,000 in equity in your home, in retirement accounts, or in investments. Do this a couple of times and you’ll easily pay off your home in 15 years, just about the time you’ll be thinking of sending your children to college.
Another area where people have debt is in credit cards. It typically starts out slowly with a vacation, a home repair, or some other sort of purchase where you start to build a balance. Once it starts, however, the interest quickly causes you to build a balance. Each time you pay off a little, another expense comes up that puts your right back where you were. Assuming $10,000 in credit card debt at 18% interest, you’re paying about $2,000 per year in interest. Without the credit card debt you’d have a couple of thousand dollars each year to pay cash for a vacation instead of using the credit cards.
Another mistake people make is buying too much home with too little down. A good limit for a home loan is about 25% of your take-home pay each month. That leaves enough cash to pay your other bills and still have some cash left over most months to put towards investments. It is also a good idea to get a 15-year fixed loan rather than a traditional 30-year loan so that your home will be paid off when you are 40 or 45 rather than just around the time you’re getting ready to retire. Once you have paid off the loan, you can then put the money you were paying towards a mortgage away and perhaps use the equity in your current home and your additional savings in a couple of years to buy a larger home for cash. You could also save for a few years and buy a vacation condo or an investment property.
By just staying out of debt you’ll have a lot more free cash. This is why people who will become wealthy have the cash needed to make purchases. Over a lifetime, they will have a million dollars or more to spend than someone who is perpetually in debt.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.