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Want to Stop Using Loans to Pay for Your Car? Here’s How to Do It.
The first time people buy a car for themselves, they typically take out an auto loan. This begins a cycle for most people. They make car payments, eventually pay off the car, and then sometime thereafter, take out another loan to replace that car.
The result is that people spend most of their adult lives saddled with a car payment that goes away for a year or two every once in a while, only to pop right back up. That car loan becomes a constant drain on their finances, requiring a monthly payment and eating up more and more of your money via the loan interest. It’s also a risk: if they lose their job for a while, and they still have a car loan, they might wake up one morning to find their car repossessed.
[ Next: How Much Car Can I Afford? ]
An effective way to solve this problem is to escape the cycle of using loans to pay for cars and instead start paying for them out of pocket. It’s actually easier than it sounds, though it takes a while to get there. Let’s walk through the game plan.
1. Pay off your current car as normal
The first step in this process is to simply get your current car paid off. You can make extra payments if you’d like to get your car paid off sooner — and that’s a great idea if you can afford it — but the primary goal here is to just get it paid off.
2. Don’t stop making car payments
After your car is paid off, there should be a period of time in which you don’t have a car payment due before you’re ready to replace the car. You should have a trusted mechanic who can tell you when there are repairs on the horizon, which is the optimal time for replacing your car; keep driving it until then.
During that period without a car payment, however, you should keep making your same car payment, but do it to a savings account. The most efficient way to make this happen is to open a savings account at an online bank and turn on a monthly automatic transfer equal to the amount of your last car payment. Then, each month, your “car payment” is automatically transferred to that remote savings account.
What you’ll find is that, over time, the money you put aside for the car actually earns a little interest. Savings accounts right now are paying about 1% APY. This means that if you have $1,000 sitting in an account for a year, not only is that money FDIC guaranteed not to be lost, it earns $10 just sitting there.
Compare that to a 4% loan. $1,000 borrowed at 4% costs you $40 for every year it’s unpaid. If you borrow $20,000 at 4% and pay it off in four years, for example, you’ll end up paying almost $2,000 in interest over the course of the loan. If you save that money instead, you’ll build about $400 in interest in that savings account over those four years. That’s a $2,400 advantage in just four years.
3. Don’t use your car savings for emergencies
It can be tempting, when saving for a big goal like this, to treat those savings as an emergency fund. If something comes up, the temptation to tap the car savings is a strong one.
Your car savings is not an emergency fund. Don’t treat it as such.
[ Read: How to Start an Emergency Fund ]
Instead, you should establish a distinct, separate emergency fund in a different savings account entirely. That money should be the money you tap in an actual life emergency.
4. Use the savings for the next car
When it’s time to buy a new car, that’s when you’re ready to empty that savings account. Transfer the full balance to your checking account and you’re ready to start shopping for a replacement. You likely have enough in cash already to pay for a similar car; if you didn’t quite make it there, you can either take out a much smaller loan or buy a slightly older car.
The advantage here is that you’re paying for that car in cash. This means you’re not paying interest on a car loan. Instead, the accumulated interest in your savings account is actually working for your benefit, enabling you to actually have more to spend on your car purchase.
[ More: 5 Easy Steps to Trade in Your Car ]
5. Keep making payments to your savings account
Once you’ve purchased that car, don’t turn off the payments to your savings account. Instead, reduce them. I recommend cutting the amount you’re saving each month by about 40% or 50%. The less you cut, the sooner you’ll be able to replace the car and/or the nicer your replacement will be, so it mostly has to do with your future car-buying preferences.
This frees up a lot of money for your monthly budget. Even better, you can sleep well at night knowing that when you need to replace a car, that money will be waiting for you. Even better, you won’t have to take out a loan for it, so you won’t be paying interest to a lender. Instead, a bit of interest will have built up for you to make the car purchase even easier.
What you need to know about buying a car
Let’s say you typically buy cars on four-year loans and drive them for a total of eight years before trading them in for a replacement. You buy a $20,000 late model used car on a 4% interest loan for 48 months. This gives you a monthly payment of $452.
You pay off the car. Instead of stopping the payments at that point, you instead start putting $450 a month into a savings account bearing 1% interest. You do this for four years. At the end of those four years, you decide to trade in your old car for a new one. You check the balance of your account: $22,026. Along with your trade-in, that’s now enough to buy the car you want without taking out a loan.
After that, you cut the amount you’re putting into the account each month to $225, freeing up $225 a month in your monthly budget with which to do whatever you want. After eight years, that account has $22,473 in it — again, enough to easily replace your car.
If you want something nicer, bump up the amount you’re saving a little. Turning it up to $250 a month gives you just shy of $25,000 in savings. Turning it up to $300 a month gives you just shy of $30,000 in savings when you go to buy that next car in eight years. $30,000 can buy a very nice late-model used car.) Alternately, perhaps your budget and tastes are a little less pricey — $100 a month into a 1% savings account gives you just a hair under $10,000 after eight years of saving.
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