A friend recently came to me, looking for advice about purchasing a new car. Now, this friend and I have some differences in our basic views about money, and particularly car payments. As you know, I believe that one should avoid car payments whenever practical. My friend believes that car payments are a way of life, and she has no plans to change.
My friend has a perfectly fine car, and she still owes about a year on the loan for it. It wasn't an large loan and the payments are around $200 each month. She is proposing that she sell the old car, pay off the loan, and buy a new car with a new loan. The old car isn't worth much more than the remaining loan balance, and she only has about $1000 to put down towards a new car. She wanted my advice.
Here is where giving financial advice can be tricky. What I want to say is, "What? Are you nuts?" and then go on about how she should pay off her old car and continue to drive it forever. However, this person isn't going to listen to that advice. I have to craft some sort of plan that would improve her finances without making her feel like I am telling her not to buy a new car.
Here's what I came up with, and I think it is a relatively good compromise.
I worked out the car payments on the new car - about$400 per month. I advised my friend that she should start making that new, higher car payment toward her current loan. If she can make the $400 per month car payment every month, for a year, without feeling like she is broke, then she will know that she can actually afford the $400 car payment. As a bonus, her old loan will be paid off in around six months. Once the old loan is paid off, she can put the $400 per month into a savings account, to be used as a down payment on the new car or as an emergency fund. A larger down payment means that she can select a shorter term for her loan, which might get her a better interest rate and will definitely help her overall financial picture. And an emergency fund is always good!
This strategy works for other credit purchases, such as mortgages. If you're considering buying a house, try paying yourself that mortgage payment (plus about 20% for the incidental expenses that come with owning a house) every month for a year. If it isn't problem, then you will truly know that you are probably capable of handling the mortgage payment for thirty years. (Plus, you'll have a nice emergency fund. Houses need emergency funds.)
While I advocate saving first and spending later, I recognize that there are times and situations where this advice isn't going to be followed. This "try it for a year" strategy takes some of the risk out of using loans for purchases by testing your ability to make the payments.