Before I relate this next story, I need to update you on my own situation. My wife and I are paying off a student loan owned by Sallie Mae. Sallie Mae has received all sorts of bad press because of their predatory nature and we are doing everything we can to escape their evil clutches. We weren't keeping track when we started but we were paying around $9.00 a day in interest a year ago to Sallie Mae. Today, we are paying $.97. How huge is that? We pay on it weekly so the interest per day goes down each week. We are hoping to have it all paid off in the next two months then it's on to the car.
Today's story is about cars. The story is true with some parts filled in with guessing by me. I'm not telling this story to give the hero of the story a hard time because everyone has done this sort of thing, including me.
Buck totalled his car and the insurance company gave him $4,000 to replace it. Buck went car shopping. Buck does not have good credit which is a common situation in today's world. I told you that I think that lenders enjoy the situation because it allows them to charge horrendous amounts of interest and people accept it. Buck is no exception to this practice.
I don't know how much he shopped around or how many people he talked to but the story that the related was that he was going to buy a new car because a bank didn't want to take a chance with him on a used car because they wouldn't be able to get their money back if Buck defaulted. Everyone knows that it's harder to get money back on a new car than an old one because a new car depreciates the most, the second that it's driven off the lot. If you were really concerned about how much money you would lose, you would direct the purchaser to a used car of low value that was likely to hold that value the longest. The dealer obviously wants to sell the most car possible. The bank weighs out the odds of getting the money bank based on more criteria than just credit score and takes the biggest possible risk that its guidelines allow.
Buck is talked into a $19,000 car. He uses part of the $4,000 as a down payment. I don't know how much but let's say half. He wanted to use the other part of the money to buy some things that he wasn't able to afford before. Buck has poor credit and so he's told that he'll be paying 18% interest. Buck accepts his lot in life and is ready to buy the car.
Buck calls a friend for advice. This friend happens to be a daily reader of this blog and has a good sense of the money game. The friend's advice is to use the $4,000 to pay cash for a used car that will probably last for a couple of years and use those two years to rebuild Buck's credit rating. Buck could save up for a down payment and not get hosed on the interest rate. No surprise but that's the same advice that I would have given.
Buck launches into all the features of the new car that make it such a wonderful purchase and it becomes obvious to the friend that Buck wasn't calling for advice but to be reaffirmed in a decision that he had pretty much already made. The friend does his job and tells Buck that the new car sounds great and that he should get it.
Out of curiosity, I ran some numbers using the API calculator which I usually do when I hear stories like this.
I used a 5 year loan because they are the most common currently. That will change. People were shocked when banks came out with 6 and 7 year loans for cars but now that the shock is over, it won't be long before the 6 year car loan is the standard.
A $17,000 loan at 18% interest for 5 years will have a car payment of around $430.00. If Buck just makes the minimum payments, he will end up paying $8,9000 in interest. That's more than 50% interest. That means that Buck is paying $26,000 for a car that is being sold for $17,000.
On top of that, Buck is going to have to increase his insurance premiums each month because he will have to have full coverage on a new car. Both factors will increase the premiums.
Let's look at the friend's advice as a comparison. We are assuming that Buck can afford the $430.00 payment for this example. If he couldn't, the bank wouldn't have let him get the new car. They would have instead directed him to a used car, telling him that he didn't qualify for a new car and that a used car would be in his best interest. Amazing how a buyer's best interest can change that quickly.
Buck could buy the used car with the $4,000 cash he has from the insurance settlement. He could get liability insurance on a used car which would keep his car insurance premiums low. He could put the $430.00 a month into the bank for two years while he rebuilds his credit. After two years, he would have $10,000 and better credit. If he were to put the 10k down on a 19k car and get about 7% interest, his car payment would be $178.00 a month and he would end up paying $1,700 in interest.
If he continued to pay the $430.00 a month on this new car, he'd have the car paid off in 16 months and only pay $400 in in interest.
He could also just buy a car with cash at $10,000 which would last him more than two years. He could continue to put $430.00 a month into the bank for his next car which could be more expensive and still paid for with cash.
Starting today, Buck could never have to borrow money for a car ever again.
A lot of money is spent on cars. In fact, car sales makes up a large part of the US economy. The economy was up in August unless you take car sales out of the equation. Then consumption was down.
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