Jerry wrote in recently with the following problem:
I and my wife are both graduate students; we recently paid off all our debts and started on a savings plan for the next few years that I am hoping will be our big downpayment on our first home. With our current salaries, we have been saving about $800 a month, with $5000 in the kitty already. However, a new situation has come up: Our current car is really old and we want to invest in a new car – (a fuel efficient subcompact). The logical thing for us to do would be to put down a sizable payment, trade in our old car, and have low monthly payments. At this stage in our lives (still being grad students) low payments are what we can afford. But I am reluctant to give up our hard saved money, especially since we have come to see it as a downpayment for our home. I dont know if I am thinking right about this, so it would be really helpful if you could give your opinion on the financially sound thing to do.
There are a lot of issues to look at here. I am assuming from the description that your current automobile is significantly less fuel-efficient than your current car and that you use it for commuting – this is based on your focus on fuel efficiency for the next automobile purchase.
The first thing I would do is calculate exactly how much you will save on fuel by switching to the new car in a given month. Let’s say your current car gets 15 miles per gallon, your new one gets 30 miles per gallon, and you drive 900 miles a month. That means your old car uses 60 gallons of gas per month and your new one uses 30. Assuming gas is $3 per gallon, switching to the new car is an immediate savings of $90 per month.
Then, I’d use that fuel savings calculation (be sure that it is conservative in terms of your actual usage so you don’t overestimate) and draw up a pre-car monthly budget and a post-car monthly budget, assuming you use all of the saved cash as a down payment on the car. My sincere advice to you is to keep saving until the down payment reduces the cost of the car low enough that there is, at the very least, no change in your monthly budget when adding in the cost of the car and subtracting the fuel savings.
Remember, the larger your car payments, the more they will slow down your progress. Not only will you not be able to save as much each month, but you’ll also be spending more each month on interest, not on the car itself. You’re always better off waiting and saving for a new car.
The best solution? You may not like it for now, but in the long run, you’ll probably be in the best financial shape if you save up for the entire cost of the car now, pay for the car in cash (and with the trade in), then start saving in earnest for the house. You’ll be in the best possible situation for the house if you do it this way, because making car payments will just slow you down.