There’s always a bit of a dilemma about investing when there’s a need to make a major purchase. Should you put your investment contributions on pause while you save for the purchase? Should you consider liquidating investments? Or should you even consider investing money to help you get the funds together?
One of the most common examples is buying a car. With the average cost of a new car currently sitting at $42,258, buying a new car has turned into a major expenditure. A price that high can force you to choose between a steep monthly payment or making a very large down payment to hold the monthly to a minimum. It’s a tough balancing act.
But how much should your car buying venture affect your investing activities?
Spoiler alert: as little as possible!
So, let’s look at how to invest while saving for a car, going one step at a time.
There’s no getting around the reality that having a reliable car is an absolute necessity. It’s not just a matter of needing transportation from one place to another—it’s also about survival. That makes buying a car a priority in a lot of situations.
Let’s face it, most people need a car to get to and from work. Unless you’re able to work from home, you’ll need to commute to earn a paycheck. The situation is even more acute if your current car is on the edge of taking its last ride.
But as important as buying a car can be, continuing to invest consistently also needs to be a priority. This is especially true if you’re young and looking to build your nest egg for the future, or even if you are older and trying to play catch-up with your finances.
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The reason why consistent investing is so important is because of compound interest. That is, investments grow faster as the income they accumulate grows and generates even more income.
It’s important to get that dynamic working in your favor early in life. For example, let’s say you invest $5,000 per year in an investment portfolio composed mostly of stocks. With an average annual return of 8%, your portfolio will grow to $238,615 over 20 years. The total of your contributions will be $100,000, but those contributions will have earned $138,615.
That’s why it’s so important to be sure you continue investing even while you are saving for a car.
Going in the opposite direction, let’s say you want to purchase a brand-new car in five years with an expected cost of $50,000. To keep the payments low, you decide you’re going to make a 50% down payment ($25,000).
To reach that goal, you delay investing. The $5000 that you would put into investments instead goes into saving for a car.
When you reach your goal and purchase the car, you then redirect the $5000 annual contribution back into investments. Over the next 15 years of contributions—still earning 8% average per year—your portfolio grows to $192,210. That’s composed of $75,000 investment contributions, and $92,210 in accumulated investment income.
By delaying investing for five years, you’ll sacrifice $46,405 in future investment earnings ($138,615 − $92,210).
This means your decision to concentrate your funds first on purchasing the car will cost you nearly twice the amount you saved for your car purchase.
When it comes to investing, starting early is an insurmountable advantage. That’s why it’s important to invest even while you’re saving for major purchases.
But what we just covered above doesn’t make the need to purchase a car go away. However, the take-away should be that saving for the car purchase, or any other major purchase, should somehow be accomplished while you continue to invest.
So, how can you make that happen?
Start by determining the amount you expect to pay for the car you want to buy. That will become the target number you’ll need to work around. But remember, it’s just a starting point. After going through the remaining steps, you may decide to purchase a less expensive car, or even opt for a used vehicle. With the high cost of cars today, either option may need to be on the table.
Once you know the approximate cost of the car you want to buy, the next step will be to get prequalified for a car loan. That will not only tell you how much you can borrow to purchase the car, but also how much you’ll need for a down payment.
If your income and credit score are high enough, you may be able to qualify for 100% financing. But be careful here because monthly payments can be budget busters.
For example, the monthly payment on a $50,000 car loan over 60 months at 3% is $898. That’s why you may want to make a large down payment even if you qualify for 100% financing.
With interest rates being as low as they are, you may also need to look at the opportunity cost a large down payment will involve.
Assuming your income is sufficient to carry the high monthly payment, financing the entire purchase price of the car could be a financial win.
For example, if the average return on your investments is 8%, and you can borrow money for the car at 3% with a fixed rate loan, you’ll have a 5% annual benefit on the exchange (8% − 3%).
Now it’s not an exact trade-off, because while the interest rate on the car loan is fixed, the return on your investments is not. If the stock market has a bad run over the next five years, taking a big loan could work against you.
Using 100% financing to purchase the car will be a financial win if the stock market produces at least average returns over the length of the loan. But there is a very real possibility the market will not cooperate, so a down payment has to be considered.
Naturally, you’ll want to make a large enough down payment to lower the monthly payments to fit neatly within your budget. But at the same time, accumulating the down payment should do as little as possible to disturb your normal investment activities.
Strategies for accumulating a down payment in a way that won’t disturb your investments, or your investment contributions can include:
Using any of the strategies above, or a combination of two or more, will enable you to save the down payment without reducing your investment activities.
If you need to buy a new car sooner rather than later, and the down payment sources listed above aren’t readily available, splitting contributions between investments and the down payment may be another option.
It’s not a perfect choice, because you will still be reducing the amount you’ll put into investments. But reducing—rather than eliminating—investment contributions will be better than making none at all. At least you’ll be accumulating additional funds and investment earnings, even if it’s at a reduced rate.
Be careful about the tax consequences of reducing investment contributions, especially if you normally direct those into tax-sheltered retirement plans. The tax benefit you get from retirement plan contributions will be reduced by the lower contribution amounts. That means redirecting funds into saving for a car will have a backdoor cost, in the form of a lost income tax deduction.
That point is especially important if you are in a higher marginal tax bracket, or if you live in a state that has a high income tax rate.
For example, let’s say you normally contribute $500 per month to a 401(k) plan, and your combined marginal tax rate for federal and state income tax is 30%. If you cut the contribution in half, down to $250, you’ll be losing the tax deduction it would provide.
With a combined marginal tax rate of 30%, the $250 that is redirected into saving for a car will cost you a tax benefit of $75 ($250 X 30%). That’ll be one of the costliest ways to raise money for the purchase of a car.
From a tax standpoint alone, it’s best to exclude reducing 401(k) contributions as a potential source of savings for a car.
The best place to park the money you save for a car is an FDIC-insured bank account.
There are several reasons why this is the best choice:
You can also save money with the same platforms where you invest.
For example, Betterment is a robo-advisor where you can take advantage of a high-yield cash account, alongside a regular investment account and an IRA. It’s an excellent choice if you like having all your assets held with one institution.
Another example is M1 Finance. It’s another robo-advisor, but one that allows you to choose the investments in your account. Once you do, your portfolios (referred to as “pies”) are automatically managed by the platform, and with no fee. Meanwhile, you can earn 1% APY in cash held in an M1 Spend Checking Account.
It’s important to keep your investments and your car savings separate, and you can do that with either Betterment or M1 Finance.
It’s certainly important to save money for a car, either for a down payment or for a 100% cash purchase. But I also hope you can appreciate the importance of maintaining your long-term investment plan at the same time.
It’s certainly a tough juggling act. But successful investing requires a long-term commitment. That means committing to regular contributions consistently. The earnings those contributions will generate make it mission-critical to begin investing as early in life as possible. The more you invest now, the more you’ll have 10, 20, or 30 years from now. And if you miss that opportunity, even for a couple of years, you may not be able to make it up later.
It’s also important to understand that while you are investing, there will be a periodic need for cash for major purchases and large expenses. That’s why it’s also important to maintain liquid savings along with your investments.
Liquid savings perform an important investment function; they enable you to deal with emergencies and large expenditures without disturbing your investment portfolio. That balance of liquid cash and investments will enable you to deal with the contingencies of life, while continuing to invest for the long term.
Put another way, your investment plan should always have a provision for major expenses. That should be true even when none are on the horizon. If you get in the habit of putting at least some money into liquid savings—while you are contributing to your investments—that’ll reduce the need to take extraordinary measures whenever a major expense arises.
Like buying a car.