In our lifetime, we will make some large purchases that will require planning. Purchasing a home, a car, a boat, another property, or a college education are all examples of these. In this tutorial, we will focus on items that cost more than $5,000. Our discussion will cover questions you should ask yourself before making a big purchase and ways to fund it.
- What is the purchase?
- What will the purchase do for me?
- How much do I estimate the purchase will cost?
- How will I pay for it? Come up with at least 2-3 methods.
- Are there alternatives to the purchase?
- Define pros and cons of making the ideal purchase?
- Decide on the purchase and ask could there be any unexpected costs?
- Do you have a plan?
The purpose of questions one and two is to get you thinking about your needs vs. wants. What would happen if I couldn’t make this purchase? Is it essential to spend a significant amount of money on it and what would happen if I didn’t buy the item? There is always a trade-off when it comes to money. If I purchase a $20,000 boat today, my opportunity cost might be that my family cannot go on vacation for the next two years. Understanding our opportunity costs can help us make confident choices about our money; helping us to avoid regret later.
One large purchase most of us make is a car. Cars vary significantly in price, and it will be essential to narrow down and research the details of the vehicle we want (or think we want). Let’s use an example of my desire to buy a new Cadillac Escalade for my family. Let’s go through the above 8 questions before I make my car purchase.
1. My ideal car purchase is a 2018 Escalade.
2. The new car allows me to transport my large family and any guests to any place we want to go to. My family needs something reliable that will last a long time, and we trust buying a new car the most. This car would make me happy, and make me feel like all my hard work is paying off. It would be a nice reward.
Determining the purchase cost is vital. The estimate requires research, and you will need to be as realistic as possible:
3. I have looked up the 2018 Cadillac Escalades online, and I know I will have to spend at least $80,000. Some models go as high as $95,000. Finding sales or rebates on this vehicle is difficult.
4. $80,000 to $95,000 is a substantial amount of money. It would be ideal to save for the entire purchase price of the vehicle and pay cash, but I don’t have the money to do that. I would need to consider other financing options to pay for this car:
- One option would be for me to save at least $40,000 to put down as a down payment and get a car loan for the other $40,000 to $50,000. If I do this, I will need to know my budget well. How much can I commit to saving each month and how long will it take me to save for the down payment. Additional items to think about will be: where will I save the money, and do I have an opportunity to earn interest on the savings to help me grow my money faster?
- If I can commit $1,000 savings per month, I can save $40,000 in just about 3 years IF I earn 6.5% interest per year, compounded monthly. This online calculator can help you play with your savings scenarios.
- To earn a 6.5% interest rate per year, I am likely to need to consider some stocks or high yield bond investments for my savings. Three years is not a long time to invest, and I know that stocks and high yield bonds can be risky. It would be better to consider a lower growth rate that is more in line with my risk tolerance and my short time frame.
- My growth rate target should be closer to 3-5% if my timeframe is less than 5 years. As a trade-off, I will need to save more per month. I can commit to saving $1,100 per month at a growth rate of 4% if I eliminate my gym membership and instead take up running, I can still reach my $40,000 savings goal in three years.
- A rate of 3-5% would lead me to invest in safer securities like quality corporate bonds or safe, established company stock. Consider any fees you will be paying to make your investment. Fees decrease your rate of return.
- If I save the $40,000 for a down payment and finance $50,000, I should estimate what my monthly payments will be. Check your bank to see what types of terms they can give you on a $50,000 car loan. You can also consider other lenders and analyze their pros and cons by using LendEDU's guide.
- How long of a loan do you want? The shorter the loan, the better the rate and the less you will pay in interest on your new car.
- Interest is the monthly fee you will pay for borrowing money. It is quoted as an annual percentage rate or APR, but it is broken down and charged monthly on the outstanding balance of the loan.
- Your credit score will determine the interest rate you qualify for on a car loan. Before you begin shopping for a loan, it is a good idea to check your credit report and clean up any errors or resolve any negative comments on your report.
- Once you get to the car dealership, you can negotiate not only the price of the car but also the terms of a loan they may offer you. If your bank offers you a 1.99% interest rate for 5 years or 60 months and the dealership is offering 2.99% they may be able to approve you for 1.99% as well, or better yet 0%. The days of 0% financing may be over because currently, interest rates are on the rise. When interest rates rise, so do the interest rates offered to you on your loans.
A great online auto loan calculator can help you estimate the monthly payment on an auto loan; try this one from Bankrate. It tells me to expect a payment of $876 per month for my Escalade. A lot of factors go into the calculation. Let’s review them to make sure we are using realistic variables. Here is an image below from bankrate.com’s calculator.
We will consider three options below.
- The amount we borrow should include the vehicle price, any taxes, and fees associated with the purchase. In this example, we used $50,000 after tax, title and license fees.
- We used a 60-month term or 5 years (shoot for 36 months if you can to save on the interest amount you will pay).
- We also used a 1.99% annual percentage rate. Be conservative using these calculators. If you aren’t confident you could qualify for a 1.99% interest rate, then change it to a higher value. It is better to plan for too high a payment then not high enough.
- Save $1,100 for only 24 months and finance the remaining balance. If we save for 24 months and earn 4% on our savings, we could save about $27,000. We would still be happy with a lower end model of the Escalade to make our total purchase price of $78,000 after all fees.
- Using the online calculator, our monthly payment for the 5-year loan, a 1.99% APR, and a loan value of $51,000 ($78,000 purchase price less the savings of $27,000) would be $894 per month.
- Option 2 costs us about the same amount as option 1 for monthly payments, and we can purchase the new car one year sooner (although it'll not be the premium $90,000 model we wanted).
Another type of financing option for a car purchase is to lease it. It is kind of like renting to own an appliance or a house. There is less of a down payment needed to lease a vehicle, and the monthly payments are usually less than loan payments. A lease is set for some number of years or months, and then you can turn the car in and get another one. The other option is you may purchase the vehicle at the end of the lease contract instead of turning it in for another vehicle.
Some drawbacks to a lease are that you do not own the asset. Therefore you are not building equity in the car. Also, there is usually a mileage restriction on the lease each year, or you will pay a fee when you return it after the lease contract is up. You may also be subject to a fee if the wear and tear on the vehicle is excessive.
Individuals who like leases are looking to drive vehicles out of their price range, like to have a new car every few years, and do not put excessive miles on their cars each year.
It is valuable to know what alternatives may exist to a large purchase which you may not have considered. Many times there are alternatives that will help you meet your needs and make you as satisfied. If you have gone through questions 1-4 and you are nervous about the savings or financing commitments needed, you should be open to alternatives. Even if you feel comfortable with the above obligations, be open-minded because you may just be better off with another goal you have if you consider the alternative.
5. Are there any alternatives to buying an Escalade?
- I could buy a used Escalade. Maybe I aim for a model from the previous year with low miles on it. New cars depreciate as soon as we sign the papers to purchase the vehicle. Therefore, it is worth considering a used vehicle that already has a lower price because it has already depreciated. If I could reduce my financed amount to $35,000, my payments can drop to $613 per month using the same terms above.
- I could buy a new (or used) GMC Yukon instead. Yukons sell for a reasonable $20,000 less than Escalades and there are possibly favorable discount opportunities or rebates. By not choosing such an expensive vehicle, I could reduce my monthly savings need, my finance amount or buy my vehicle sooner.
6. What are the pros and cons of making my ideal purchase?
- Pros: An Escalade would make me feel accomplished and luxurious. It is large enough for my family, and it is reliable new or used.
- Cons: I would have to commit quite a bit to save for a down payment, my monthly payments to finance the rest of the purchase price are high, I would have to commit to a 5-year loan, I have to give up my gym membership, and I would be afraid someone would scratch my new car.
Review your answers to all of the above and make a decision: remember your alternatives, be realistic whether or not you can afford the purchase, what else is given up in your budget or will you have to sacrifice other goals to make the purchase?
7. It’s time to make a decision.
For the Escalade purchase goal, I am going to go with an alternative purchase of the 1-year-old GMC Yukon. This decision will help keep my monthly savings and finance payments to reasonable levels. With an Escalade, my budget would be uncomfortable, and I would lose my sense of financial freedom.
Be prepared for unexpected costs. I found in my research that new tires are quite expensive for these large SUVs so I will have some money set aside for that purchase in a couple of years when needed.
8. Define steps:
- Save $800 per month for 24 months with a target growth rate on my savings of 4% per year.This should allow me to save $20,000 for a down payment.
- I prequalified for an auto loan through my bank at 1.99% APR. If I finance for 48 months, my payments will be a comfortable $750 per month for financing $35,000.
- My total purchase price after fees cannot exceed $55,000.
- The other $300 of discretionary income ($1,100 I could commit at the beginning less the $800 I decided to save) will go towards retirement savings each month.
In two years I will be ready to make my large purchase of a new vehicle. This is the same process we use for any other big purchases as well. It is essential to know all your options and to think them through thoroughly. Don’t rush your decision-making process.
If you are unsure about your purchase, seek advice from a professional or from someone you trust. Go through your ideas together and let them help you think it the pros and cons. Ask for the best places they know to make your purchase. Maybe they can refer you to a friend or someone who can help you get the right price. Sometimes knowing the right people in a car dealership may help.
Our final thought about making large purchases is to have a plan for if the purchase becomes a burden down the road. Don’t be afraid to make decisions that will better your situation if the purchase was a mistake or your financial situation changes. Sell the item that is beginning to cause you stress or financial ruin. No one will think poorly of you for making the right decision. Making tough choices is what makes you a success. Do what is best and don’t allow your financial independence to suffer because of your ego.