Your Car Payment Is A Huge Roadblock To Financial Freedom

I must live in a bubble. Because in my circle, I don't know anybody who has a car worth more than 1/10th of their annual gross income.

• My dad drives a 28 year old car that's worth maybe $500 and he has a government pension worth at least 100X that.

• I drive an 11 year old car worth maybe $15,000 and my passive income is more than 10X that.

• My friend drives a 10 year old Tesla Model S worth maybe $16,000 but makes over $5 million a year.

• A neighbor just paid off his house and celebrated by buying a three-year-old Honda Civic. He's 42 years old and already semi-retired.

I came up with the 1/10th rule for car buying over 15 years ago to help people achieve financial freedom sooner. Thousands have followed this standard rule since, but millions more have not.

If you had invested $60,000 back in 2012 in the S&P 500, you would have about $405,000 today. But if you used that $60,000 to buy a 5 Series BMW, it'd be worth less than $9,000 today. Yet people still insist on buying cars for absurd amounts while they are guaranteed to depreciate and rack up ongoing maintenance expenses.

A car is the number one personal finance killer for most Americans. Therefore, your car payment is also the main roadblock you have to financial freedom.

Your Car Payment Crowds Out Investments

When you have a car payment, that money gets sucked into paying off a depreciating asset rather than investing in a potentially appreciating one. The car payment also becomes a distraction. It's one more financial account you have to stay on top of, instead of staying on top of your investments.

I found this insightful video on Twitter that highlights how a car payment can hold you financially back. She is most likely joking about her huge car payment, but it's worth having a discussion anyway because there are some folks in a similar situation. Have a watch and listen:

This example hits home because my wife is looking to become a full-time preschool or kindergarten teacher. So far, she's worked as a substitute teacher for $24 an hour for four days over the past month. If she works 40 hours a week, 50 weeks a year, she will gross $48,000 a year. This is on top of online school she is currently taking plus homework.

The woman in this video is a top tier kindergarten teacher earning $7,500 a month, or $90,000 a year after taxes. Kudos to her, especially if she doesn't live in an expensive city like San Francisco, LA, Seattle, or New York. Also, I like how she is spending $251/month on a gym membership and a personal trainer. Exercise is crucial for a better life.

However, with a $1,548 monthly car payment on her Mercedes Benz G Wagon, she doesn't have much left each month. In fact, she ends up at negative $124, which she borrows from a friend.

Used To Own A G-Wagon Myself

It is funny, because when I was 25 I foolishly bought a G Wagon in 2002 for $75,000. I had just gotten a raise to Associate with a base salary of $80,000 (up from $55,000) and a guaranteed bonus from coming over to Credit Suisse in San Francisco from Goldman Sachs in NYC. As a naive young man, I decided to blow a ton of money on a car I did not need.

I thought it was a steal since G500s were selling for $150,000 out of a dealership in Santa Fe, New Mexico the year before. That dealership had held the exclusive import rights, which Mercedes bought out. After only one year I got rid of my G Wagon once I decided to buy a condo. The thing was too tall to fit in the garage. Ultimately, I took a $17,000 bath on it.

It was actually that experience that led me to come up with the 1/10th rule for car buying. I remember seeing the car saleswoman raise her arms with joy and high-five her manager once I bought the car. I did not want anybody else to go through the same financial stupidity I had just put myself through.

Nothing Wrong With A $9,000 Car Instead

School teachers are the best. They have the most important occupation in the world and are therefore underpaid. But G Wagons cost between $150,000 and $200,000 today, which is 167% to 220% of her annual salary. That is a far cry from my recommendation of spending 10% of your salary on a car.

Kindergartners are not going to give you more gold stars because you showed up in a G Wagon. In fact, their parents might start asking some uncomfortable questions when they see their kid's teacher pulling into the parking lot in a $150,000 SUV.

A second-hand $9,000 vehicle would work just fine for this teacher making $90,000. There are plenty of models to choose from.

The X Factor: Working Spouse

What gives me comfort about this situation is that this kindergarten teacher has a spouse who paid her gas bill. And given that I believe people are generally smart and rational over the long run, it stands to reason her spouse likely makes enough money that she felt secure buying a $150,000 vehicle with a $1,548 monthly car payment.

Based on my 1/10th rule, their household income should be somewhere between $1.5 and $2 million a year. So it is possible her husband clears more than $1.41 million a year, which puts him in the top 0.1% of earners. So awesome if he does.

Even if they ignore my 1/10th rule entirely and spend closer to 20% of their household income on the purchase price of a car (1/5th), they are likely making $750,000 to $1 million combined. Not bad as a top 1% income earner.

I refuse to believe that with all the free financial education out there, this household would purposefully torpedo their finances and sentence themselves to working forever just to fund luxury expenses. And then, to make a social media video about it would be illogical, which is why I'm pretty sure she is joking for views.

After all, investing $150,000 today at an 8% annual return leads to $323,850 after 10 years. That's a nice chunk of change!

Make Rational Decisions And You Will Be Financially OK

At the start of this article I was surprised by her car payment. But thinking through it logically, this teacher and her spouse will probably be fine. She has friends who will float her when she runs short. She has a husband covering her gas and extras.

Ultimately she'll be fine. Because if this car payment were true and things get tight, or she decides she wants out of teaching sooner, she will logically sell the car and downgrade her expenses. Until then, she will love pulling up to school in a $150,000+ automobile and soaking in every bit of attention that comes her way. At this moment, those benefits outweigh the costs for her. And that is perfectly rational. You do you.

There is one thing I do want to flag though, and that is her house to car ratio is completely out of whack.

One of the quiet traps of renting is having more monthly cash flow, which makes it tempting to spend on things like a fancy car. That is exactly what I did the first three years out of college. I bought a Volvo 850 GLT, BMW 5.40, BMW M3, and a G-Wagon as a car fanatic. Easy to do when you have no mortgage staring you down.

If she and her husband want to genuinely improve their odds at financial independence, they should get neutral on real estate by owning their primary residence. After that, get the house to car ratio to 50 or below. With a $9,000 car and a ratio of 30, all she needs is a $450,000 house to hit that hurdle. Otherwise it is work forever until death, which sounds dramatic but is simply math.

Reader Questions And Suggestions

Readers, why do some people take out massive car payments on an asset they know will only go down in value? Do you think car payments are the most common roadblock to financial independence? Why not just buy a cheaper second hand car and invest the difference? Nobody is stopping you either way. Just know the tradeoffs.

Instead of buying an expensive car with a large car payment, invest that money in the S&P 500, bonds, and real estate. Ten years later you will be glad you did. Personally I am dollar cost averaging into Fundrise commercial real estate right now because valuations are low compared to stocks. With four years of underbuilding due to high interest rates, I expect rent and pricing pressure to rise in the coming years.

Fundrise is a long-time sponsor of Financial Samurai and Financial Samurai is a six-figure investor in Fundrise products. I'm looking to diversify and earn more passive real estate income given managing rental properties is a PITA.