Car finance: how to pay cash next time

My wife and I just finished paying off her car loan, which was financed at an outrageous 14%. Of course, I'm never again going to willingly take out a loan like that again. It got me thinking, though. At some point in the future, when maintaining this Toyota gets to be more expensive than buying a new car, we'll want to buy a new car. At least, a "new to us" car. So, how do we do that?

First, let's look at how much that loan would have cost us if we hadn't paid it off early. The original amount financed was $8319.36. Financed at 14% for four years, that's 48 payments of $227.34. The total amount paid would be $10,912.32, of which $2,592.96 is interest. Ouch! That's all avoidable interest, by the way. As outrageous as 14% is, though, it's probably a typical interest rate for somebody who finances at a car dealership and has poor credit, so I'll be using it in my example below.

Here's how you can buy your next car for cash, pay less than asking price, and avoid paying all that interest. First, since you can afford the monthly payment of $227.34 when you're buying a car, you can afford to put that much aside and hang onto your old car for a while. That's right, I said save that money. Pay it to yourself first, before you spend money on eating out and all that other stuff that eats away at your budget.

At $227.34 a month, you've accumulated $2,728.08 in the first year. Assuming your dream car costs about $10,000, it will take 3.66 years (or 3 years, 8 months) to save that much. But wait, there's more! You're not just socking away your money in a mattress. Ideally, you're putting it into some investment that will see some interest. I'll use my Emigrant Direct account as an example. It pays 4.00% at the time of this article. With this interest added on, you're looking at one of two things: you can afford to buy a better car (interest will add on $754.46 to your $10,000 saved, for a grand total of $10,754.46), or you can buy your car sooner (at 3 years and 5 months instead of 3 years, 8 months).

This illustrates the power of making interest work for you, instead of against you. I like that this plan gives you incentive to maintain your old car for as long as you can, instead of switching cars every year or two. If your car lasts longer than you thought it would, you can use part of your savings for something else. If it doesn't last long enough to save enough money for a new car, you'll probably get a much better financing deal if you have a substantial chunk of money for a down payment.

I admit, I'm a nerd. I love using my financial calculator to play around with numbers. In some future post, I'll talk about time value of money, and give some examples of how to use a financial calculator.