I recently came across the How to Drive Free and Retire Rich on Dave Ramsey’s site. It basically said the normal way thinking about car ownership is all wrong and there is a better way to go about this. Dave Ramsey proposes that you save your money first, invest, and use the proceed to buy your cars. After a while, you will accumulate enough money to make your car purchases self-funding for life, leaving you with enough cash flow to fund your retirement — which could be worth $5.5 million after 40 years. Essentially, the basis for “Drive Free” and “Retire Rich”.
The Drive Free Method
According to Dave Ramsey, most Americans take out a car loan to buy a car. For a typical $26,000 car, the average monthly payment is $475 at an average interest rate of 9.6%. And after 6 years of ownership you’ve paid almost $33,000 for your $26,000 car, which is now worth may be $6,000. At this point you’re probably thinking about a new car and the cycle continues.
Dave Ramsey challenges the normal way and advocates these different ideas:
Let’s say you have a car that’s worth $1,500 today. Instead of going out and buy a new car, save the $475 for 10 months and you’d have $4,750. Add that to the $1,500 and you could upgrade to a nicer car that’s worth $6,250. You can keep going an in another 10 months trade up to a car that’s worth $11,000.
That’s pretty sweet!
Invest the Savings
Since the new car loan in the scenario above is 72 months, let’s continue saving $475 per month for the next 52 months. Assuming you invest your savings in a mutual fund that returns an average of 12% per year, you’d have $32,000.
By this time, your $11,000 car is quite old. Let’s say you spend $12,000 to buy another used car, you’d still have $20,000 left. This means that if your investment continues to earn 12%, you could afford to buy $14,000 to $18,000 cars every five years for the rest of your life.
The Retire Rich Part
Since you’ll never spend another dime on your cars for the rest of your life, you are now free to invest that $475 per month for your retirement. If you keep investing $475 per month in the same mutual fund returning 12%, you’d have
- $100,000 after 10 years,
- $470,000 after 20 years,
- $1.6 million after 30 years, and
- $5.5 million after 40 years
Too Good to Be True?
This sounds wonderful doesn’t it? My dad always said, “if it’s too good to be true, it probably is.” I think this is the case here. To be perfectly clear, I think Dave Ramsey’s How to Drive Free and Retire Rich is a great concept and it works. However, I think the numbers he presented is a little bit hyped up. For example:
- First, the most glaring problem I see is the 12% return on investment. The stock market has not performed at that rate for a long time. And some experts believe the more realistic level is closer to 8-10%. Let’s call it 9% for our purpose.
- Second, short-term investing for 12% gain is not that practical in real life — over the span of 10-40 years…yes, that makes sense, but not 52 months. The stock market is volatile and your principal is not protected. For example, if I were following this Drive Free Plan and were waiting to buy my next car in 2008, almost half of my “car fund” would have been wiped out by the stock market crash. You cannot depend on a plan that involves investing in the stock market to achieve a short-term goal.
- Third, Dave Ramsey didn’t mention capital gains tax. When your investment increases in value and you liquidate, you’ll have to pay capital gains tax. For most people, the long term capital gains tax rate is 15%. This means that you’ll have to liquidate about $14,000 to spend $12,000.
- Last but not least, there are a lot of expenses involved when you buy a car. For example, sales tax, destination fee, and registration fee — just to name a few. These fees add up quickly and could be significant depending on the price of the car.
A More Realistic Math
Let’s make the Drive Free and Retire Rich more realistic. Here are some changes
- Average car loan interest rate 4.21% for a 60 months loan (source: ValuePenguin)
- Average new car price for midsize car and small SUV is $26,000 (source: Kelly Blue Book)
- Average stock market return is between 8-10% (source: Investopedia)
The S&P 500 Index originally began in 1926 as the “Composite Index” comprised of only 90 stocks. According to historical records, the average annual return since its inception in 1926 through 2018 is approximately 10%. The average annual return since adopting 500 stocks into the index in 1957 through 2018 is roughly 8% (7.96%).
So here are some of the changes
|Loan Length||72 months||60 months|
|Length||52 months||52 months|
Again, I think Dave Ramsey’s How to Drive Free and Retire Rich is fantastic. However, the numbers he presented is a bit optimistic. As you can see the revised numbers is a fair bit less, but still great. Can you imaging that a $475 monthly car payments could cost you almost $2.25 million over the course of 40 years? That is absolutely mind boggling.
Can you imaging that a $475 monthly car payments could cost you almost $2.25 million over the course of 40 years?
So what can we take away? Well, here are a few good points that Dave Ramsey made:
- Don’t buy new cars. Buy used cars that meet your needs.
- Avoid financing. Try to save money and buy with cash instead.
- The less money you spend on cars, the more money you’ll have to invest for your retirement.
So what do you think? Let’s hear it.
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.