(Money Magazine) -- Question: I'm 29 years old, earn $75,000 a year and have $130,000 in my 401(k), $5,000 in a Roth IRA and $50,000 in a savings account for emergencies. I save roughly 15% of my salary each year for retirement. I currently drive a seven-year-old Honda that's fully paid off, but I've been thinking buying about a new Lexus that would cost $43,000. I'm not sure I can afford it, though. I would put $15,000 down, which I have in separate savings, and finance the rest with a three-year loan. But that would leave me with a rather high monthly payment, so I'm wondering if I'd be better off saving more for a larger down payment or taking out a five-year loan instead. What do you recommend? --Y.S., Philadelphia, Pennsylvania
Answer: Although you haven't couched the question this way, I think there are actually two issues you ought to consider here.
The first is how much of your financial resources at this point in your life you want to devote to upgrading your ride as opposed to providing yourself a greater margin of financial security. The second is how you should pay for a new car, be it the Lexus or any other one you might buy.
Let's start with the financial resources question.
Clearly, given the substantial amount of money you have tucked away in an emergency fund, the nearly two times annual salary you've stashed in 401(k) and Roth IRA accounts and your impressive savings rate, you're off to a very good start in creating a high level of financial security for yourself.
Indeed, if you go to our What You Need To Save calculator and plug in your age, salary and retirement savings, you'll see that you are in that rare group of people who are more than on pace toward a comfortable retirement.
So while I certainly don't want to encourage spending habits that would knock you off that course, the fact is that you've already saved enough to give yourself sufficient financial wiggle room to be able to splurge a bit if you wish.
That said, forty three grand is a lot of money to devote to what fundamentally comes down to transportation. If you put $15,000 down and finance the remaining $28,000 over three years, you're talking about a monthly payment of $854 a month, or about $10,250 a year. That's nearly as much as the $11,250 (15% of your $75,000 salary) you're socking away in retirement accounts now.
You can lower your monthly payment, by opting for a loan with a longer term. But if you check out the going rates for car loans of varying terms in your area and plug the relevant figures into an auto-loan calculator, you'll see that, even with a 60-month loan, you're still forking over about $550 a month, or $6,600 a year.
So at the very least you've got to ask yourself how taking on this new commitment on will affect your ability to save for retirement. Will you be able to pay off the car loan while maintaining your current savings rate? Or will you have to cut back?
Even if you decide to pay for the car a different way -- more on that later -- the fact remains that you're diverting resources that could go toward enhancing your financial security into a car.
We're talking about a tradeoff here. Financial security vs. enjoyment today. Clearly, where you come down on that depends on how much you feel that new Lexus will improve your life compared with enhancing your future financial prospects. You might reasonably conclude that, given your current savings, you're more than comfortable on the security front.
On the other hand, you're only 29 and who knows what life and the financial markets might bring over the next 30 to 50 years? A little extra cushion on the financial side might not be a bad idea. Maybe you could compromise and buy a car that costs $10,000 or $15,000 less than the Lexus, allowing you to savor that new-car feeling without giving up as much in financial security.
Obviously, that's a subjective calculation only you can make. But I think it's one you ought to think about at least.
Whatever type of car you eventually settle on, you'll still have to face the question of paying for it. Here too, there's no "correct" answer. But given that car loans these days average 6% or more annually -- and the rate you're likely getting on your emergency fund is more like 1% or 2% -- I'd do my best to keep the loan term as short as possible and the loan itself as small as possible.
I like your idea of driving that Honda a little longer to give you time to save more. Who knows, maybe combining some additional savings with the $15,000 you've already earmarked for a new car and then dipping into your emergency fund a bit (while still leaving at least three months' living expenses) will allow you to pull this off with a very small loan or even no loan at all.
One final note: as part of your decision-making process, I suggest you take a spin over to the Autos section of our site. You'll not only get the latest news on everything from luxury to economy models there, you'll also find practical tips on how to get the best deal on a car and, should you end up needing one, a car loan as well.
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