In the last post, I talked about how it wouldn’t be a good idea for anyone on the path to early financial independence to blow their hard earned money (earnings or savings) on a shiny new toy. Yes, the Tesla Model S is an amazing car, but NO EXCEPTIONS! 🙁
There was nothing groundbreaking about that last article, as everyone knows, you can’t keep buying up liabilities if you want to get ahead in life. No, you need to focus your efforts on buying up assets that put money in your pocket each and every month, instead.
However, sometimes life just happens! For instance, cars do break down and there will come a time when we all need to purchase a replacement vehicle.
If you follow the personal finance “gurus” they will all advise you in the exact same way. If you want something, you had better buy it in cash! NO EXCEPTIONS! Credit cards are evil, and don’t think for a second about taking out a high-interest loan. If you don’t have enough money now, well too bad! You aren’t allowed to make any purchases until you have the necessary funds at your disposal. No loans, period. Never ever forget, debt is your enemy and you want to avoid it like the plague.
Sound familiar? I’m sure you’ve heard that lecture a million times before. Luckily, if you’ve been a follower on this blog, you already know how I feel about debt… I believe that debt is the key to amassing massive wealth at an early age. Yes, it’s risky… there’s absolutely no denying that. However, just like nuclear energy, if carefully utilized, it can do a tremendous amount of good as well. In fact, good debt is so useful in helping investors build wealth that they’ve renamed it completely and don’t even refer to it as debt… We are talking about leverage here.
How does this apply to cars? Well, let’s say your car breaks down and you need a new one. The old one isn’t worth salvaging and there’s no other reliable way for you to get to work. Being the practical person you are, you decide that you don’t want to overpay for a new car. Ok, so no Tesla Model S for you. Let’s say you have ~$25,000 to work with. You want to buy brand new and drive that thing into the ground. In other words, you want this to be the last new car you ever purchase for a long, long, long time. Who knows, by the time you are ready for the next upgrade, Teslas may actually be mainstream and affordable. 😉
Here’s a practical car for a frugal person on their way to early FI:
The Market Finance Rate of 2.99% was auto-generated by Edmunds, and is current at the time of this post.
For a vehicle purchase, the cost of credit (i.e., the interest rate) expressed as an annual rate. Edmunds pre-populates this field with the Gold-tier finance rate value from the Edmunds.com Finance Rate Estimator for your geographic region and for the loan term you select. This interest rate is the prevailing rate being charged by banks and other direct automotive lenders to consumers who fall into the second-highest credit tier (which encompasses the majority of the car-buying population).
So, you could buy the car all cash for about ~$25,000, or finance over six years, instead, at $383/month. Again, if you are used to hearing advice from personal finance experts, your first thought will probably be to buy it straight cash. Who wants to pay interest, right? Even if it is only a measly 2.99%…
I would choose to make that interest payment. 2.99% is chump change, and you’ll be able to make almost any kind of investment that will return a higher yield than that.
The most important thing, in my mind is the opportunity cost. If you buy that car with all cash, you can kiss that tidy sum of ~$25,000 goodbye. Once it’s gone, you won’t be able to get it back…
However, if you hold on to it, here’s something you could do with it.
These days, I like to talk about investing in rental property in the Midwest. No, I’m not particularly enamored with that area or anything like that. I just like to go where the numbers make sense. If this was still 2012, you wouldn’t hear me talking up the Midwest near as much… I would be too concentrated trying to score more bargains in my local market (Bay Area).
However, times have changed, and as an investor you just have to roll with the punches and adapt. With ~$25,000 at the ready, here is what I would do instead of buying that car in all cash:
First off, I know that the car costs $25,193… If that’s my budget, I would try and locate an investment that would require that same amount of capital. If we can find a Midwest property for $80,000 purchase price, a 31.5% downpayment would require $25,200, which is roughly the same as our all cash car purchase.
If we can locate such a property that rents for $1075/month (reasonable number), this would give us a net cash flow of $387.84/month (factoring in gross rent reserves of 5% for vacancy and 10% for maintenance). This equates to a cash-on-cash return of 18.47% (probably too high for a turnkey investment in today’s market, but reasonable if you do-it-yourself) for the 31.5% downpayment.
There’s nothing special about the 31.5% downpayment number. I simply adjusted the percentage until the downpayment was about equal to our all cash purchase.
And there you have it. For the same capital investment, you would now own an asset that cash flowed enough ($387.84) to pay for the car ($383.00) each month.
Note: With financing on the car, you would also probably need to budget 10% or so ($2500) for the car downpayment… This runs up the costs slightly… But who knows, if the dealer is desperate to sell or needs to meet quota, maybe they will settle for less money up front?
After six years, you would not only own the car free and clear (same as if you had purchased the car all cash), but you would ALSO own an income producing asset.
Since you utilized leverage to purchase the property, you would also have six years’ worth of principal paydown on the mortgage! Does it get any sweeter than that? Yes, in fact it could. After six years, any appreciation on the house is yours to keep as well.
But to me, the most important thing is opportunity cost. Had you purchased the car outright, you would have had to wipe away your investment capital and needed additional time to rebuild that back up… By the time you are ready to invest again, who knows where the market will be? Will properties still be affordable? Will interest rates be too high? Will the returns even be worthwhile?
By pulling the trigger on the investment early, you are able to lock-in the opportunity. It doesn’t matter if housing prices escalate afterwards, or if interest rates continue to rise. You’ve already secured your investment. 🙂
Apply THIS Everywhere
This is how the game is played. This is how the rich get richer. They don’t use their own money to buy things. They let their investments buy all the toys. This is how you secure financial freedom early in life… You buy assets, and then you use your assets to pay for all your bills and expenses.
Why stop at a car? Once the car is paid off in six years, use that same asset (remember you still own this income stream) and pay off some other bills.
And don’t stop there. Keep on acquiring more and more assets to pay for other things. Try to eliminate your cellphone, utilities, internet, food, gasoline, etc… Pretty soon, you’ll be able to live completely “FREE“. All your expenses will be covered by your passive income. That’s the dream after all, right?
After Early FI
The point of this exercise is not to suggest a life of complete deprivation… Quite frankly, if you are able to get to early FI then you deserve to have some fun… and even nice toys! 🙂
The problem, though, is if you are on the journey to early FI, you haven’t yet achieved financial freedom. Indulging prematurely is in essence taking a few steps back. Until you have a massive passive income snowball knocking out your monthly expenses with ease, you need to focus on ONLY one thing — keep acquiring more income producing assets.
Once successful, do whatever you want! In fact, go out and buy a Model S. Or two. Even put down a downpayment for a Model X. At that point though, I bet you’ll be savvy enough to have enough passive income streams coming in to pay for those as well. Who doesn’t like FREE!?!
Like most good things in life, there is a catch. As mentioned previously, leverage always carries with it some degree of risk. Even if you buy carefully, investing is never guaranteed. For example, if your cash producing asset runs into any trouble, you’ll be on the hook for not only the car payment, but also the mortgage associated with the property.
So, always tread carefully. The best way I know of to do this is to build up a solid cash buffer… This should always be an on-going effort. That, and if you are going to use rental properties as your means of generating passive income, try and acquire more than one unit. Duplexes are nice because they let you hedge on vacancy. Even if one unit goes empty, you should still have enough cash coming in from the other unit to at least cover the monthly mortgage payment.
However, if you are willing to take the risk, and have the stomach for it, leverage can be a very powerful tool in helping you become wealthy sooner rather than later. While most people will look to pay for a new car with all cash, you can have your cake and eat it to.
The alternative approach, again, is don’t buy the car outright and purchase an investment property instead. Find a solid return on the investment and take out a 5-6 year loan on the car, or however long you need to make the monthly payments work. The monthly cash flow from the investment needs to exceed, or at a minimum break even with the car payments. Again, to minimize risk, aim for more margin.
If you play it right, after a few years you’ll own that SHINY new toy for FREE! And that investment property will keep on cash flowing…
Isn’t that just music to your ears? 🙂