Cars are a budgetary black hole, and one we don?t always fully comprehend. On Friday we discussed the high and rising cost of new cars in Are You Feeling Priced Out of the New Car Market. The price of a brand-new car today averages about $32,000, making it unaffordable for the typical middle-class household earning something near the median household income of about $51,000. Today we?re going to take a look at using a sinking fund to control car expenses – a strategy you can implement at any time during the car owning process to get the upper hand on costs.
According to the Automobile Association of America (AAA), the total cost to maintain a car is 60.8 cents per mile, or $9,120 if you drive 15,000 miles per year. That?s the entire range of car related expenses, including gas, repairs and maintenance, insurance, auto loan interest, and depreciation. It works out to be $770 per month, and that?s just the average cost to maintain one car.
Using a sinking fund to control car expenses
Car expenses can be difficult to manage because they sometimes come in large chunks. We can usually skate by paying for gas each week, or the occasional oil change, or a monthly auto insurance charge that?s direct debited out of a bank account. But then there are those other times when you?re hit with a massive repair bill ? like $2,000 ? or the need to come up with several thousand dollars to make a down payment a new car. Those are events that can put you into a mini-financial emergency.
That?s where a sinking fund comes in. A sinking fund is primarily a financial term. Most often, it represents an account that’s used to accumulate funds for the purpose of paying off a corporate or public debt. These loans are typically interest only arrangements ranging in term from 5 to 30 years. In order to payoff the loans, the institution must establish an account that it gradually funds so there will be sufficient money to pay the debt off completely upon maturity
We can use a sinking fund to control car expenses, and it will make car ownership a lot more tolerable ? and sometimes even less expensive.
Covering car repairs on older vehicles
One of the major reasons people cite for buying a brand-new car every few years is avoiding major car repairs. The thinking is that if you buy a brand-new car, and trade it in after five years, you?ll be avoiding repair bills that can run into thousands of dollars.
There is some logic to this line of thinking, but it ignores the fact that you?re mostly trading one set of expenses for another. For example, while it?s true that repair expenses tend to run higher with older cars, they typically average no more than $2,000 per year. Compare that with a new car payment of $500 per month, which works out to $6,000 per year.
From a purely financial standpoint, the decision to stay with newer cars is a complete disaster. Thinking about it another way, the extra $4,000 that you will spend each year for a new car over a used car ($6,000 in payments on a new car, minus $2,000 in repairs on an older car) will drain you of $20,000 over a five-year period ($4,000 per year X five years).
Maybe people are finally becoming aware of that equation. The average age of a car in the US is now up to a record 11.4 years, and seems destined to go even higher due to intractable economic realities, particularly relating to jobs and income. But that?s not entirely bad news ? especially on a personal finance level. A well-maintained car can certainly last a lot longer than five years. One of my car repair contacts tells me that it?s routine for commercial vehicles to be extended to over one million miles!
A sinking fund to control car expenses can make keeping an older car much easier. You can think of it as an emergency fund, but it is one that is specifically set up for your car. And if you have more than one older car ? as many households do ? a sinking fund can be an even bigger benefit
Let?s say that you have a car that?s 10 years old. You can pretty much predict that your repair expenses will run something on the order of about $2,000 per year. Rather than taking chances, and having to come up with a big chunk of money whenever a repair occurs, you anticipate it happening by funding the sinking fund on a regular basis.
If you put $167 per month into the fund ? and you can do this through direct payroll deposit ? you will be creating a fund that will provide $2,000 each year to cover repairs on your car. In this way, you?ll be evening out the peaks and valleys in owning an older car. You?ll benefit from the fact that you will not have a large monthly payment, but you?ll always have the money available when a major repair hits.
A sinking fund will also open up options. Since you already have the money allocated to pay for the repair itself, that will leave you open to renting a car for a day or two in the event that your car is tied up in the shop. The car expense sinking fund will make owning an older car much more predictable, and much more pleasant.
By being able to keep your older car longer, you will save money not only on monthly payments, but also on the higher insurance and ad valorem taxes that newer cars have.
Paying off car loans ahead of schedule
We mentioned earlier how sinking funds are used by institutions to retire debt. You can use your own car expense sinking fund to do the same thing with a brand-new car.
Let?s say that for budgetary purposes you decide to take the six-year loan (72 months) on a new car purchase. The payment is certainly more comfortable than it would be for a shorter term, but you aren?t at all happy knowing that you?ll be making payments for so many years, and that the value of the car is likely to drop below the loan balance at some point along the way.
Much like an institution that has a loan retirement sinking fund, you can use your own sinking fund to pay off your car loan early.
Let?s illustrate this with an example. You buy a brand new car, at the national average price of $32,000. Your trade in comes to $6,000, requiring that you take a new loan of $26,000. On a 48 month loan at 4%, the monthly payment would be $587. But to keep it tolerable, you finance the car over six years instead:
Loan amount: $26,000
Term: 72 months (six years)
Interest rate: 4%
Monthly payment: $407 (rounded)
Let?s say that even with the lower payment the six-year loan provides ($407 vs. $587), you?re still not comfortable making payments over a 72 month timeframe. Using a loan amortization calculator you determine that four years into your six year loan, you will still owe about $9,000 on the loan.
Here?s how a sinking fund can help you payoff the 72 month loan in just 48 months. By dividing $9,000 over 48 months, you determine that if you put $188 per month into your sinking fund, you?ll have the money that you need to payoff the loan at the end of four years.
Now the monthly payment, plus your sinking fund contribution, will be roughly what the payment would be a four-year loan. The important thing is that your required monthly payment would still be just $407 per month. That would give you the option to not make the sinking fund contribution in a month where your expenses are unusually high. The sinking fund gives you more control over your money, particularly over a period of several years.
You would get the benefit of the lower required monthly payment under the 72 month loan term, but the sinking fund would enable you to payoff the loan in just 48 months ? and with greater control of your money along the way. This is something like creating your own balloon payment arrangement, except that you control the details, not the lender.
Saving money for the next car purchase
Let?s say that you decide that you never want to have another car payment ever again. A sinking fund would help you to do that. It?s a strategy for buying a car on a cash basis, rather than paying for?it?in arrears with a loan arrangement.
How does the sinking fund work for a new car purchase?
Most people are accustomed to the idea of making a monthly payment when purchasing a car. With the sinking fund, you essentially make the monthly payment before you buy the car. You determine the purchase price of the car that you want to buy, less than expected trade-in on your current vehicle.
Using similar numbers from above, let?s assume a $32,000 new car, with a $6,000 trade-in. That means that you will need to come up with $26,000 between now and the time you purchase the car.
If you plan on replacing your car in five years, that will mean you?ll need to save $5,200 per year in each year, or about $433 per month. Since the price of the car that you are looking to buy probably will be more expensive in five years than it is right now, you may have to save a little but extra, or extend the amount of time that you need to save.
That may seem like a lot of money, but it?s probably less than the typical monthly payment on an average new car. In the meantime,
- You?ll have complete control over the money until the time of purchase,
- You won?t need to take a loan to buy the car,
- You?ll be an all cash deal, giving you a much stronger bargaining position with the dealer, and
- Once you buy your next car, you can start a sinking fund for yet another new car, without having to worry about a car payment on the vehicle you just purchased.
The sinking fund strategy can work even better if your plan is to buy a used car, since both the contributions to the fund, and the length of time you?ll need to make them, will be shorter. If you do decide to setup a sinking fund, make sure that the account is strictly for car expense, and no other purpose. Car expenses have become a serious cost, and dealing with?them requires more organization and strategy than we often give it.
Does a sinking fund make sense to you as a way to control your car expense?