If you take out a $200,000 loan for 30 years at 4.5% interest, how much in debt are you?

Some might argue that you’re only $200,000 in debt. However, when you look at the payments you’ve committed yourself to making over the years, you’re actually promising to make payments totaling $364,813.20.

Thus, I’d argue that your actual debt is $364,813.20, even though you actually only received $200,000 in cash out of it.

It’s kind of a scary way to think about it, isn’t it? You get similar scary pictures when you look at the federal budget and examine the pledges we’ve made for future Social Security payments. If we’ve promised to pay it, it’s reasonable to include it as part of our indebtedness.

In fact, I’ve actually moved to calculating my net worth in this way. This number reflects the payments I’m obligated to make in the future. Yes, if I were to liquidate all of my possessions, I could reduce that number, but it’s not realistic to think that I’m going to liquidate my possessions to pay off a mortgage. If you think liquidation is a reasonable assumption, then by all means calculate things with just your debt total.

So, now you’re $364,813.20 in debt. You’re going to have to repay that much money over the next thirty years. You’re going to make 360 payments, one per month, of $1,013.37 each (do the math – if you multiply $1,013.37 by 360, you get $364,813.20).

Here’s the interesting part. Let’s say you add just $1 to just the first payment. This single extra dollar paid drops the entire debt by $2.83. You turned $1 into $2.83 in terms of your net worth. Not only that, you’ll also have your final payment reduced by $1 beyond the $2.83 in interest savings.

Essentially, you invest $1 now and you get it back in 30 years. Along the way it reduces your debt for you by $2.83.

Let’s say you add $100 to just the first payment. You reduce the entire debt by $283.33. You get the $100 back in 30 years and, along the way, it reduces your debt by $283.33.

Let’s say you just add $1 to each payment. You reduce the entire debt you’re going to pay by $399.16. You get your $360 back at the end of the 30 years, plus it reduces your debt by $399.16.

Every time you add a little extra to the payment, the total payment amount you’ve agreed to play goes down. Your obligations are reduced for the future. Not only that, you get the extra money you added back at the end of the debt in the form of a smaller final payment.

For me, the easiest way to keep track of this and of the impact of an extra payment is to use a sophisticated mortgage calculator like this one at Bankrate or, better yet, this Microsoft Excel template. I keep my mortgage data stored in this calculator so that I can see the impact of any extra payments I might make and so that I can see how much I really owe going forward assuming I just make the minimum payments from here on out.

Why think of things this way? For me, there are really three reasons that stand out for looking at debts this way.

One, this method makes it clear how much you’re actually obligated to pay. A $200,000 debt doesn’t mean that you’re obligated to make $200,000 in payments. It means you’re obligated to make quite a lot more.

Two, it’s very clear how much of a positive impact early debt payments can make on your future obligations. The impact is large. Thanks to calculating things in this way, one can really see the big impact extra debt payments make to one’s future obligations.

Three, it lets you see how powerfully debt repayment compares to investing. Without using this method, early debt repayment doesn’t have a powerful impact on your financial bottom line. In fact, it has no impact for the time being – it only shows up very gradually as future payments begin to take advantage of the lowered principal and less of your payments go toward interest. An investment, on the other hand, can quickly begin showing returns that directly show up on your balance sheet.

If you do use this method, though, you can quickly see the long-term impact of an extra debt repayment on your bottom line. Your obligations are immediately lowered by that extra payment, which lets you breathe easier.

To me, knowing my total obligation instead of my total debt feels like a more financially honest approach. It’s the same approach many of us are demanding from our government, so why not apply it to ourselves?

A few weeks ago, I put out a call on Twitter and on Facebook for detailed posts that people would like to see. I got enough great responses that I’m going to fill the entire month of July – one post per day – addressing these ideas.

On Facebook, Tyler wanted to know, “Should I stop my retirement contributions while i pay back my college loans? I am 23 and my employer will match up to 5% of my contribution. Should i continue? or hold off until my loans are paid?”

The challenge with any question like this is that it relies so much on future events. What will the stock market do over the next thirty or forty years? That’s unknown. What path will Tyler’s life take over the next ten years or so? That’s unknown as well. Both of these factor enormously into answering the question above.

The best thing we can do is follow some reasonable approximations and rules of thumb for future investment growth while also striving to give Tyler as much freedom as possible in the coming years.

The Ghost of Investing Future
In order to get an estimate of how much someone should be investing for retirement, you have to come up with a few basic assumptions.

When will the person retire? This lets us know how many years of investing we’ll be able to account for. I’ll asume that Tyler will retire at 75, giving us 52 (!) years to work with.

How much of an annual raise can we assume? I usually just match this at the same rate as inflation. Speaking of inflation…

How much inflation should we assume? I usually peg this at 3%, which is pretty sound based on the economy of the last twenty five years.

How much of an annual return on stocks can we assume? Warren Buffett projects a 7% annual return over the long haul in the American stock market, so I’ll use that number.

Do you see how tenuous all of these calculations are? When you estimate retirement savings, you’re making a lot of guesses for the future.

What you’re going to shoot for is an amount high enough so that the person’s annual expenses equal 4% of the total savings at the time of retirement.

I ran the numbers, assuming that Tyler is able to live on about 75% of his salary each year. My calculations showed that Tyler should be saving somewhere between 9% and 10% of his annual income for retirement, so we’ll use 10%.

10% is an excellent thumbnail to use. In this case, Tyler has the advantage of a long period until retirement, but I’m also using some pretty conservative returns on his investments for my calculations.

Tyler’s Choice Today
In order to make it to a healthy retirement, Tyler needs to be saving 10% of his annual income starting today. He can choose to delay it a few years, but then he’ll be locking down 11% or 12% or more to make it to his goals. He’s a lot better off locking things down at 10% starting today.

Tyler’s employer will match up to 5% of his contribution, so if Tyler contributes just 5% of his salary today, he’ll be on pace for what he needs for retirement. This is exactly what I would recommend that Tyler does.

Once that’s taken care of, he should throw every dime that he can at his debts. It is far easier to live a little lean now when you’re single and aren’t weighted down with responsibilities than to live lean later on when you’re burdened with career and personal requirements.

Should Debts Ever Delay Retirement Contributions?
This is a tricky one to answer. Quite often, people eschew retirement savings in order to pay off debts because they don’t want to make lifestyle changes. This is a giant mistake. If you find that you’re in a situation where you can’t make your minimum debt payments, a small retirement contribution, and live your current lifestyle all at once, changes need to be made with regards to your lifestyle first and foremost.

If you are in a situation where further lifestyle changes genuinely are not possible – meaning you have no cable or satellite bill, no cell phone, no new or nearly-new car, no living quarters larger than you need, etc. – then you should take care of your high-interest debts before renewing your retirement savings. Of course, this does need to be coupled with an emergency fund and a commitment to avoid debt in the future, because without that, this is all a moot point.

Personal finance almost always comes back to impulse control, and this is no different. If you can’t control your impulses and desires when it comes to spending money, financial success will almost always be elusive in your life. You won’t get ahead if you can’t control yourself.

Quite often, when I write answers to reader mailbag questions, I encourage people to keep pushing hard against their debts no matter the interest rate. Almost everyone agrees that it makes sense to rapidly pay off the 15% debts, but I’ll often get a lot of disagreement about the 3% debts. People will often ask why they should hurry to pay off a 3% debt. After all, they can get a better return in other investments.

The reason is simple. It’s all about the cash flow.

Let’s start off with the basics and explain what cash flow is. Cash flow refers to the amount of income you take in minus the required bills you have to pay. Ideally, you have money left over at the end of this process, and the more cash you have left over, the better. That cash can be saved for the future, invested, or applied to extra debt payments.

Let’s say, for example, that you’re bringing home $3,500 a month. You have a $1,000 mortgage at 6.75%, a $500 student loan payment at 3%, and another $1,000 in required bills (electricity, food, fuel, etc.). At this point, you must have $2,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $1,000 to do with what you please.

Now, let’s look at your situation if the mortgage is paid off. You still has a $500 student loan payment and another $1,000 in required bills. You must have $1,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $2,000 to do with what you please.

Because your mortgage is paid off, your monthly cash flow is far better than before. This helps you in countless ways.

Let’s say you lose your job and can only find one that gives you a 40% pay cut. At this point, you’re bringing home only $2,300 a month. In the first scenario, you have $2,500 in required bills. You’re going to have to make some major scary cuts in your life in order to make ends meet. In the second scenario, you have only $1,500 in required bills. You’ll be just fine and still have a surplus.

There are countless other examples of life changes, planned or otherwise, that can significantly alter your income. The greater the amount of required bills each month, the more difficult it is to swallow those life changes.

This is why it’s nearly always useful to improve your cash flow. Improving your cash flow improves your life options. It makes job transitions far less painful, for one. When you’re fired or “downsized,” you can take a lower paying job without pain. On the other hand, you also have a lot more flexibility with your career choices as you’re able to take a lower-paying but more career-building job. In fact, this is exactly what I did: I paid off a lot of debts, which reduced my monthly required payments and made it easier for me to live on less income, which enabled me to switch to writing The Simple Dollar full time because my cash flow was in much better shape.

The worse your cash flow situation is, the more you’re tied to your current job. It gives your boss more power and you less power because the threat of losing your job is devastating. Your job becomes more stressful by default because the always-present threat of losing that job – and the pain it would cause – is always hanging over your head. Your career options are limited, too, because you can’t deal with a reduction in pay.

In short, pinching your cash flow pinches your options.

Debt pinches your cash flow, of course. For example, getting a car loan pinches your cash flow because you’re now responsible for those payments. On the other hand, living without a car loan for a while and saving up for your next car is a much better cash flow option, as it allows you to simply pay cash for the next car, keeping your cash flow as wide as possible.

Overspending pinches your cash flow, too. If you needlessly spend a lot of money, you’ve pinched your cash flow for that month. You take money away from your savings. Thus, at a later point when you need that cash for a purchase, you’re forced to rely on debt, which forcibly pinches your cash flow.

It’s because of these things that I usually encourage people to just get rid of all of their debt. Eliminating all of your debt opens that cash flow up, making it easy to save for the future, change to a different job, or make other significant life changes that would be nearly impossible with a constant debt payment hanging around your neck.

Carolyn writes in:

For the longest time, I’ve been making larger than minimum payments on all of my debts. I got the idea from Suze Orman because she said that if you just make minimum payments, you’ll never get rid of debt. I have two credit cards and a student loan. Here are their interest rates and outstanding balances and minimum payments:

Credit card 1 – 19.99% interest – $3,400 balance – $57 minimum payment
Credit card 2 – 15.99% interest – $4,000 balance – $55 minimum payment
Student loan – 6.75% interest – $41,000 balance – $470 minimum payment

What I’ve been doing is putting $700 in payments towards these debts each month, but I have been spreading out the extra among the loans. This means adding $39 to each payment, giving me a payment of $96 on the first card, $94 on the second card, and $509 on the student loan.

Is this the right way to go?

Suze is both right and wrong here. She’s absolutely correct in making the point that if you make just minimum payments on a debt, you’ll find it takes decades to fully pay it off. Even worse, the longer you take to pay off a debt, the more money you pay in just interest on your debt – it’s just money lost.

However, she’s not quite right on the idea that you should make larger-than-minimum payments on all debts.

According to my back-of-the-envelope math on the three debts you named, it will take about thirty years to pay off each credit card with just minimum payments, and just under ten years to wipe out that student loan with just minimum payments. If you use your alternate plans with a bit larger payments on each debt, you save about $6,000 in total interest, pay off each credit card in about five years, and pay off the student loan one year earlier. In other words, you’ll go another five years without eliminating any of the debts.

I agree with making overpayments, but I think you should channel all extra payments to the highest interest debt. In this case, that’s the credit card with the 19.99% rate. If you make a $117 extra payment on that debt each month, you’ll pay off that debt in a year and a half. At that point, you can apply a $174 extra payment (the $117 extra payment you were making, plus the $57 you were making on that first debt that’s now eliminated) on the second credit card, paying it off in about a year and a half. You can then apply a $229 extra payment each month to that student loan (the two minimum payments, plus the $117 in extra payments) and eliminate that student loan in about seven and a half years (total).

That simple shift will get you to debt freedom one and a half years earlier than before.

This is called a debt repayment plan, and the basic idea behind it works no matter how many debts you have or what type they are. You just order the debts by interest rate, make minimum payments on all of the debts, and make the biggest extra payment you can to the debt with the highest interest rate.

You may also want to do things like negotiate with your credit card companies for a lower rate. The worst thing they can do is lock your account, which doesn’t matter a bit if you’re not using it, and you might just see a nice interest rate reduction, saving you even more money.

Just stick with contributing $700 toward your debt every month and you’ll be fine.

You’re in a relationship. That relationship is starting to get serious. You’re contemplating marriage or some other form of long-term commitment.

Now what?

Quite often today, people are bringing significant debt into relationships with them. Credit card debt. Student loan debt. Auto loan debt.

I often get emails from readers asking me how to deal with them. Should they keep these loans separate from each other? How much debt should they really share?

This was also an issue that Sarah and I struggled with when we got married. After some struggles, we eventually came to a conclusion that really makes the reality of these debts quite clear.

First of all, regardless of who actually owns the debts, they are now shared debts. When you’re married, your money effectively becomes a shared pool, whether or not you directly share that money or not. If one of you has a debt, the money to pay for that debt comes out of the shared pool. What’s left in that shared pool is smaller, reducing your opportunities as a couple to build towards other financial goals.

When we were married, for example, I had an auto loan and my wife had an auto loan. I had student loan debt, as did my wife. I had credit card debt, as did my wife.

At first, we each tried to handle our own debts. What we discovered, though, is that after covering these debts, we each had much less left over to contribute to the things we shared – rent, energy bills, food, and so forth.

Even though we were keeping our debts separate, the reality was that the consequences of those debts were shared. If the consequences are shared, then it follows that the responsibility for paying off the debts ought to be shared as well.

Which brings me to my next point: once you acknowledge the debts as essentially shared, the optimal way to get rid of those debts is to consider them all together. It should no longer matter who has the worst debt. What matters is that the worst debt is the one that you both focus on first.

When my wife and I reached this conclusion in 2006, we began to really work together to focus on all of the debts either one of us had. It didn’t matter whose name was on the credit card or on the car title. The consequences of those debts were shared, so we both benefit when any of those debts go away.

Doing all of this successfully requires complete openness. You can’t hide debts from each other. You can’t hide money from each other. You can’t hide spending splurges from each other.

Whenever you do these things, you are taking money out of that shared pool that helps you both get what you want from the future. You’re also being dishonest with your partner and, likely, you’re undermining your debt repayment plan and other financial plans for the future.

This type of dishonesty is acid to any relationship. It opens the door to other forms of dishonesty that can completey destroy a relationship.

Any relationship where things are not completely in the sunshine is a relationship that’s eventually asking for problems.

If you’re not comfortable with that openness, then your relationship needs work. This goes beyond mere finances. It’s an indication that there are trust issues in your relationship and as long as those trust issues exist, you’ve got a gigantic fault line in your relationship that can easily erupt into a earthquake.

Simply put, share your debts. Regardless of who brings them to the table, you share the consequences, so you should also share the effort of eliminating them. This can also help you to pay them off in a more optimal fashion.

You’ve realized (finally) that you’re in a precarious financial situation. You’re spending more than you earn – sometimes quite a bit more. You’ve racked up a fair amount of debt. Now, you’re seeing that some changes are going to have to happen in your life, but those changes sound utterly painful.

What do you do?

Getting to Zero
The most vital thing that you must do in this situation is “get to zero.” What do I mean by that? Getting to zero means that you’re trimming your spending enough that your income matches your spending. If you bring home $2,000 a month, you can spend only $2,000 a month.

In order to make this number, I usually encourage people to look for big changes – single moves that can save them a bunch of money each month. Some options include eliminating cable, eliminating a telephone landline, moving into a smaller apartment, downgrading to a less-expensive car, bundling your insurance, refinancing your mortgage, or renegotiating your credit card interest rates. Almost everyone is capable of making at least one of these changes, and such a change can make a huge difference in your month-to-month spending.

Sometimes, though, making one or two big changes isn’t enough. The next step is to focus on what I call “one-off changes.”

One-Off Changes
These changes revolve around activities you can do once to either bring in a quick money spike (which you would then apply to paying off a debt) or to lower a bill for the foreseeable future.

Some options here include cleaning out your closet and selling off unwanted items, having a yard sale, selling off the contents of a collection on eBay, installing a programmable thermostat, replacing light bulbs with more energy-efficient ones, air sealing your home, and/or putting your home electronics on a more energy-efficient plug setup (with the devices set to a switch or to a “master” outlet that cuts power to the other devices when the master one isn’t in use).

The one-off options that produce a money spike can be applied toward your debts, preferably the smallest debt. Ideally, you’ll be able to pay off at least one debt very quickly, which naturally reduces your monthly bills.

The next step is the part that people think of as being “painful” when it comes to making more frugal choices.

Behavioral Changes
These changes revolve around making better choices every day. We’re constantly inundated with choices that have some financial consequence, from the moment we get up until the moment we go to bed.

Should I grab a bite at home or grab something on the road for breakfast? Should we go out with coworkers for lunch? Should I stop at a store on the way home? Should I hit Starbucks? Should I order take-out tonight? Should I go out with my friends or stay home? Should I buy this neat item from Amazon or hold onto my cash? Should I prep some stuff for tomorrow or should I just turn on the whole home entertainment system and veg out?

Each one of those situations is a choice, and each one has a financially good and a financially bad option. Quite often, it seems as though the expensive option is easier or more fun, and it seems utterly painful to give them up. It is choices like this – where you’re made to give up something you enjoy – that gives frugality a bad name for some people.

If you’re in that boat, I encourage you to not give up big swaths of stuff. That approach will leave you feeling miserable and will inevitably lead to a big backlash against making changes. If your heart is not into a big change in your life, you’ll never make that big change.

Instead, I suggest a different route. Simply focus on the choice you have at hand. Don’t make big plans about giving up Starbucks only to find yourself resenting it later. Instead, whenever you have the option to stop at Starbucks, ask yourself whether you’d rather stop or you’d rather put yourself in better financial shape. If you choose to stop today because you could really use that giant cup of sweet coffee, then go for it and don’t think twice about it. On the other hand, view it as a personal success if you decide not to stop today.

Retaining What You Save
What I usually encourage people to do is, once they’ve reached zero and are spending only what they bring in, they start directly setting aside every dollar they save to get rid of their debts.

Let’s say you’ve decided not to stop at Starbucks. At that point, literally take a $5 bill out of your pocket and put it up, or log onto your online banking service and move $5 to another account. You can also just track this with a pocket notebook with a note that says “$5 – saved by no Starbucks.”

Over time, with every good choice you make, it’ll add up. “$10 – didn’t buy that book and hit library instead.” “$12 – made dinner at home and ate leftovers for lunch.” “$8 – used coupons at the store.” “$30 – stayed home with friends instead of going to a club.”

Remember, you’re looking at individual choices here. If a choice seems too hard, don’t make it. Do not let yourself get miserable because of frugality. What I found at this stage is that most of the time, making the financially sensible choice felt really good – better than what I was giving up. I was proud of it. However, there were certainly times when I didn’t want to make that good choice, and I found that if I forced myself to do it, I ended up resenting the whole thing. Don’t fall into that trap.

The perfect is always the enemy of the good. You’re far better off making three good financial choices and two ordinary ones and feeling really good about it than making five good financial choices and resenting your life so much that you eventually backslide out of everything.

As these numbers add up, make sure you’re putting that amount to good use. It is a bad idea to make these good moves, then look at your checking account balance, think that you’re rich, then spend it all on something silly. Instead, pour that money into improving your financial situation by paying off debts, building an emergency fund, saving for a down payment, and so on. Use a debt repayment plan and make sure your dollars are going toward something powerful.

A reader who asked for anonymity wrote in:

I’m visiting a lawyer next week to get started on filing for bankruptcy. I have no way to pay my debts or even make the minimum payments each month. My problem is that I simply can’t find a place online that actually explains what the different kinds of bankruptcy are and how they work in any terms I can understand. What’s Chapter 7 and Chapter 11 and Chapter 13?

I’ll attempt to explain these concepts in the clearest terms I can. Of course, when you do that, you tend to lose some details in the process, so if you want to know more about your specific situation, I suggest contacting a lawyer.

What Is Bankruptcy?
Bankruptcy simply means that you can’t pay off your debts and you’re asking the legal system for help. This event appears on your credit report and can have a negative impact on your credit score for seven years, though being diligent about following through with the plan developed in bankruptcy court means you can minimize that impact. It also means that the court system will come up with some sort of plan that works for both you and your creditors for you to pay back some portion of your debts. The exact way you do that differs depending on the type of bankruptcy.

Typically, bankruptcy is an option of last resort. It has legal costs which can add up to the thousands and a very negative long-term impact on your credit. You should only turn to this if you cannot come up with a successful debt repayment plan on your own. I suggest creating your own debt repayment plan and making a serious effort to execute it on your own before considering bankruptcy. Credit counseling can also help; in fact, it is legally mandated before you file for bankruptcy.

Chapter 11 Bankruptcy
Chapter 11 bankruptcy is usually the best option if you own a business. This form of bankruptcy typically allows a business owner to remain in control of their business while going through bankruptcy proceedings. This typically occurs if you own a business that isn’t able to pay its bills at the moment. If you do not own a business, Chapter 11 is not right for you.

Chapter 7 Bankruptcy
Chapter 7 bankruptcy is a “liquidation” bankruptcy. You can typically only use this type of bankruptcy if you have sufficient income – usually more than the median income in your state. If you qualify, what happens is that some portion of your possessions are sold and the money from selling those possessions are used to pay off your creditors.

You’re allowed to keep some of your possessions during this process depending on the specifics in your state. This usually includes your home, your clothing, minimal transportation, a few hundred dollars’ worth of personal possessions, your pensions, and a few other odds and ends. The rest of your assets are liquidated and used to pay off the creditors. At the end of this process, your creditors go away, but your credit report has a big black mark on it and you’ve lost many of your assets.

If you hear stories of people repeatedly filing for bankruptcy, that usually means they’ve adopted some form of lifestyle where they repeatedly file for Chapter 7 bankruptcy. They usually don’t accumulate assets and spend the debt money they accumulate on experiences. Then, when they file for Chapter 7, there aren’t many assets for the creditors to take.

Chapter 13 Bankruptcy
Chapter 13 bankruptcy is the most common type of bankruptcy. In this form of bankruptcy, you and your legal counsel come up with a debt repayment plan. During the process, the plan is usually adjusted a bit to match the creditor’s demands and your own ability to repay such debts. Often, these plans lower your monthly payments to the point that you can actually handle them within your income. Often, that also means that your total debt amount is lowered.

What’s the drawback? For starters, the cost usually is in the thousands – this is tacked onto the court-ordered debt repayment plan. The plan itself usually ties up almost all of your spending money for a few years as you’re paying off debts. It also damages your credit severely, as does any bankruptcy, but your successful repayments will help mitigate that damage.

Which Is Right for Me?
For most people, Chapter 13 is the best route. Chapter 7 is better if you’re a high wage earner with few assets. Chapter 11 is the one to consider if there’s a business involved.

Of course, the specifics of bankruptcy vary somewhat from state to state. If you’re considering any of these avenues, contact legal representation before you move forward and make sure you understand the specifics in your state.

Your best choice, of course, is to avoid being in a situation where you’re concerned about this in the first place. Hopefully, this advice helps those who need it – and encourages people heading in that direction to reconsider their path.

Quite often, I get emails from readers asking about the “best” way to purchase a particular car that they want. They have their eye on some new model and want me to essentially tell them that it’s okay to purchase it.

I rarely do. Taking out a loan for a car is only a good move if (a) you’re buying your first or your second car and absolutely need one today to commute to work – and even then, you should be buying a used one or (b) you have enough cash to buy the car you want but you’re offered 0% or extremely low financing, making it cost-effective to take out the loan and then sit on your investment (a pretty rare case, but one we found ourselves in recently).

We fully own both of our automobiles and don’t intend to replace either one of them for years. Of course, we’re slowly saving up for their replacements at a reasonable rate, but we’re not paying interest – interest is working in our favor.

Let’s run the math so that you can see, in real dollars, how much is saved by paying cash. You have no cash at all, but you need wheels. What do you do?

Option 1 – Buying New Now
You go to the dealership and take out a $25,000 loan on a new car. That loan is offered to you at 6% for five years, meaning you have a monthly payment of $483.32.

You drive this car for seven years. Each month, you pay $483.32 as a car payment. After five years, you own the car, but you’ve paid out $28,999.20 for the loan – $3,999.20 of that being pure interest. You then start saving $483.32 a month for your next purchase – after two years, your savings account totals $11,715.68 ($11,599.68 in savings, plus $16 in interest).

At the seven year mark, you trade in your used car for $6,000 in trade in and also make an $11,700 down payment on your next $25,000 car. You’re still borrowing $7,300 to buy the car, which means monthly payments of $141.13 over the next five years, totaling $8,467.80 – $1,167.80 of that being pure interest.

At this point, you also need to save $285 a month so that you have $25,000 in cash ready for your next car purchase at the fourteen year mark – seven years after this one. $23,940 of the savings will be cash and the rest will be interest – $1,104.64.

So, after all of this, you wind up paying out $73,006.68 over the course of these fourteen years and find yourself with a new car at the end of it.

Now, let’s look at fourteen years starting in a different fashion.

Option 2 – Buying Used Now
You go to the dealership and take out a $5,000 loan to buy a used car that will work for five years. You make monthly payments of $483.33 each month. For the first year, $430.33 of it goes towards the loan payment, while the other $53 goes into savings. For the remaining four years, the whole $483.33 goes into savings.

At the five year mark, you have just shy of $25,000 saved and the trade-in on your junker puts you over the top. New car time, paid for in cash. You then start saving for your next new car in seven years, saving $285 a month.

At the twelve year mark, you replace that car and keep saving the $285 a month. At the fifteen year mark, you have a three year old car and $10,414.67 in savings.

Over the course of all of this, you’ve actually only shelled out $63,199.80 out of your pocket for these cars.

Comparing These Two Scenarios
Here’s the real take-home message here: simply by buying a low-end used car at first in the second scenario and driving it until the owner could pay cash on a new car (at the five year mark), that owner saves $10,000. In other words, choosing to take out a loan for a new $25,000 car means that $10,000 is simply evaporating out of your wallet.

Remember that from here on out, both scenarios are going to be saving the same amount of money in their savings account to keep up with future car replacements, which essentially means that the money is a car payment.

I like to look at it this way: the owner of the second option is essentially paying himself $2,000 a year to drive a used car instead of a brand new one.

There are a few additional things to point out as well.

First, the insurance costs in the second scenario are lower as well. For those first five years, the person owns a used car which will have lower insurance costs than a new automobile.

Second, considering used cars in your buying decision can save you money. When you run the numbers on your car purchase, always include used cars, particularly ones from model years with a good reputation. Sometimes, those cars can save you significant money over the long haul through insurance savings, plus they allow you to retain some of your cash savings for your next car purchase.

Finally, having the money in the bank puts you in control. If you can buy the car in cash, you’re no longer worrying about your credit history or about whether a bank will offer you a good rate. You have your cash, you find the best deal, and you buy. Simple as that.

I’ll say this much: every time I run the long term numbers with regards to paying cash or taking out a loan for a car, I further reinforce my own plan to never again borrow a dime for a car (unless, as I mention above, I have the money in an investment that offers a better guaranteed return than the interest rate of the car loan).