Back in 2018, I decided to join a local softball league in San Francisco. I was one year into being a stay at home father and I was determined to expand my social network. Tennis had always been my sport, but I thought it would be nice to mix things up.
The softball league turned out to be a great outlet. I met people from various parts of the Bay Area from different socioeconomic backgrounds. The person I developed the best relationship with was the organizer named Steven.
Steven was a preschool teacher who helped manage some of his parents' properties. As a property fanatic myself we talked about various investment opportunities, such as buying up ocean view properties in the city and investing in the heartland of America due to the heartland's lower valuations, higher cap rates, and stronger migration trends.
The Arrival Of A New Tesla
Then one weekend, Steven showed up for the game in a brand new red Tesla Model 3. The Model 3 had just come out and Steven crowed on and on about how amazing the car was. He even showed me how he could back his car up using his iPhone while standing outside.
I was impressed! But at the same time, I was dismayed that he had spent $53,000 for a car I thought he could not really afford.
As the creator of the 1/10th rule for car buying, I strongly believe that paying more than 10% of your gross salary on a car is a poor financial move. Paying too much for a car is probably the most common financial mistake Americans make today.
I didn't know exactly how much my friend made, but I'm sure he didn't make over $530,000 as my 1/10th rule would dictate. As a 32-year-old preschool teacher, my guess is Steven made closer to $70,000 a year. In other words, Steven spent a whopping 75% of his gross income on his new ride or almost 100% of his after-tax income.
As a new friend, I wasn't about to judge Steven for his purchase. Instead, I just listened to why he loved the car so much. His enthusiasm was as high as a bench warmer who had just hit the game-winning single.
The True Cost Of Owning A Car
The true cost of owning a car isn't just the cash necessary to purchase the car. Other costs include:
* Monthly payments. If you don't pay 100% cash for your car, you've got to pay a fixed monthly lease or loan payment. A lease payment is made to basically renting the car and return the car back to the dealer after a certain time period with zero equity.
If you want to terminate the lease early, you will likely have to pay an early termination fee. A loan payment, on the other hand, slowly pays down the debt owed on the car. Although you will eventually own the car outright, if you have an interest payment higher than 0%, your total cost to own the car will be much greater than had you paid cash upfront.
* Maintenance. Depending on your warranty, you will have to pay for oil changes, flat tires, and broken parts. Once, I had to spend $700 to fix my car fan because it randomly stopped working three months after my warranty expired.
* Insurance. If you plan to drive your car legally, then you must get car insurance. Even the most basic liability insurance will cost you several hundred dollars every six months. If you want comprehensive insurance, where your insurance covers all vehicles involved in an accident, expect to pay much more.
More Costs Of Owning A Car
* Tickets. If you drive in a big city, expect to get everything from parking tickets to traffic tickets. Traffic and parking tickets are important revenue sources for the city. It is not a mistake that some parking instruction signs are difficult and confusing to understand.
If you don't get a parking ticket, you will likely get a street cleaning ticket. If you don't get a parking ticket or a street cleaning ticket, you may eventually get a moving violation ticket for not coming to a complete stop at a stop sign.
* Accidents. The more you drive, the more likely you are to get into an accident. If you do get into an accident, expect to pay your full deductible. Once the insurance company covers the cost of repair, expect to get charged a higher semi-annual premium during the next coverage cycle.
I once accidentally scraped the side of my Honda Fit into a parking pillar when backing up. The total cost to straighten out and paint two panels was roughly $3,400!
Biggest Cost Of Owning A Car: Opportunity Cost
All of these costs are why following the 1/10th rule for car buying is so important. If you keep your car purchase low enough, you can withstand practically any “surprise” cost.
But there is one cost that may trump all other costs combined: opportunity cost!
After hearing Steven go on and on about how great his Tesla Model 3 was for three weekends in a row, I decided to test drive one to see what all the hype was about.
The test drive was an experience like no other. Driving a Tesla makes driving an internal combustion engine car feel so antiquated. Not only is the ride powerful and smooth, but every time there is a software update, the car performance gets a little better.
In honor of Steven's purchase, I decided to buy about $50,000 worth of Tesla stock in October 2018 at $298/share. Surely, the stock was going to be a winner!
Tesla ended up rising to $367 a share shortly after, making me a cool $11,500 on paper. During the next six months, Tesla began melting down as fears of bankruptcy emerged. By June 3, 2019, Tesla was down to just $179/share. My $11,500 paper profit had turned into a $20,000 paper loss!
Once again, I was reminded that trying to pick individual stocks to outperform the S&P 500 is a fool's errand. Luckily, the market has started to recognize the potential of Tesla's growth and re-rated the stock in 2020. One thing shareholders do know is that owning Tesla stock is going to be a very bumpy ride!
Understand Opportunity Cost
Although purchasing a Tesla car versus owning Tesla stock is perhaps an extreme example of missing a potential investment gain because you instead purchased an over-priced car, understanding opportunity cost is critical for controlling your spending.
Since 2009, the S&P 500 has been on a tear. Therefore, almost at any point since 2009, you could have invested in the S&P 500 and made more a year later. Of course, there will be some bad years like in 2018 and in 2020 so far. Besides, the prices for new luxury cars are now incredible expensive. Save your money!
Over the long term stocks tend to go up at a 10% annual rate. Meanwhile, you can always investment in bonds, real estate, or other investment classes that have historically gone up over time.
Always Calculate Opportunity Cost
Remember, before buying your next vehicle, not only should you calculate all the direct costs associated with owning the vehicle, you should also calculate the potential opportunity cost.
If you haven't reached financial independence yet, then paying more than 1/10th of your annual gross income on a car is definitely a mistake. You could have invested the downpayment or the monthly payments in stocks, real estate crowdfunding, or other asset classes that have historically appreciated over time.
As for my friend Steven, he actually is experiencing the best of both worlds. Not only is he enjoying his Tesla Model 3 every day, but he also revealed to me he also invested in Tesla stock when he purchased his car. He has made enough from his profits to own his car outright and then some. But he's not going to pay off his car loan because he plans to own Tesla stock for the long-term.
I decided to sell 65% of my Tesla holdings at over $800 on May 12, 2020 and ride the rest forever. I'm very thankful the stock market has recovered so strongly since melting down in mid-March!
Invest In Real Estate Instead Of A Car
Paying money for a new luxury automobile is a waste of money, especially if you are not financially independent yet. Cars are depreciating assets that won't make you money in the future. Instead of paying for a car you don't need, use that money to invest in real estate instead.
Take a look at Fundrise, my favorite private real estate investing platform. Fundrise was founded in 2012 and manages over $3.3 billion with over 500,000 investors. The firm focuses on single-family and multi-family properties in the Sunbelt, where valuations are lower and cap rates are higher. For most investors, investing in a diversified private real estate fund makes the most sense.
Another great private real estate investing platform is Crowdstreet. Crowdstreet offers accredited investors individual deals run by sponsors that have been pre-vetted for strong track records. Many of their deals are in 18-hour cities where there is potentially greater upside. Crowdstreet is a solution where you can build your own select real estate portfolio. I've met the people at Crowdstreet on two separate occasions and came away impressed with their product offerings.
Personally, I've invested $954,000 in private real estate since 2016 to diversify my exposure and earn more passive income. Both Fundrise and CrowdStreet are affiliate partners of Financial Samurai, and Financial Samurai is currently invested in Fundrise.