By the end of 2007, I plan to have $20,000 in my emergency fund. (Remember, I “borrowed” some money from my Emergency Fund so that I could fully-fund my Roth IRA’s for 2006. I am in process of “paying myself back”.) Since I’ve been thinking about purchasing a “new” car, I started thinking about how rapidly I could save $10,000 by the end of 2009.
First, I found this awesome calculator and I entered the following:
Number of years: 2 (January 2008 until December 2009)
Annual Rate of Return: 4.5% (Current ING Direct Rate)
Opening Balance: $20,000
Monthly Savings: $325
Ending Balance: $30,025.61
For the 24 month period from January 2008 until December 2009, I will deposit a total of $7800 ($325 X 24). Adding that to the amount of interest that I will make during that same period of time (about $2200) and I will arrive at my grand total of $10,000. So, in two years, I could purchase a $10,000 automobile after making $7800 in “payments” to myself.
Notes: The above calculations assume that I will NOT have to use my emergency fund funds for any other purchases, that the interest rate in my ING account will not dip below 4.5%, and does not include tax that I will pay on interest earned.
Now, let’s assume that at the beginning of 2008, I decided to finance an automobile and that I wanted my payments to be $325 per month. How much of an automobile could I afford? Just for simplifying the calculations, let us assume that I am going to get financing at 4.5%. I realize that this number is “low” for a used car, but let’s just keep things “simple”.
I could FINANCE the purchase of a car at 4.5% for 24 months, with payments of $325, and I could buy a car valued at $7445.
Over a 24 month period, I would make 24 monthly payments of $325 (totalling $7800). Over that same time, I would pay the finance company $353.95.
So, the difference, in this example, between saving $325 per month (and adding this money to the interest that my savings account is already accruing) and financing a car purchase for $325 per month, is about $10,000 – $7445. So, by saving for my purchase, instead of financing it, I can get $2500 MORE car.
Notes: Using my method, I will have to delay the purchase of the car for 2 years. But, whenever I make the purchase, I will be getting a ‘nicer’ car.
Now, suppose that, instead of sticking with the $325 payment, you simply wanted to purchase a “$10,000” car, financing it at 4.5%. Now, what would be your total cost?
I could FINANCE the purchase of a $10,000 car, for 24 months, at 4.5% with payments of $436.48. Over the life of the loan, the total amount of payments plus interest would be $10,475.52.
Now, back to my plan. In two years, I will have turned $7800 plus interest into about $10,000. If I were to finance a $10,000 car at 4.5%, I’d be “out” $7800. That, my friends, is a $2600+ difference!
The above just gives a taste of the power of interest working FOR me instead of AGAINST me. In the “real world”, I hope to make a better return on my money than 4.5% and there are very few people who qualify for used-car loans at 4.5%. So, the difference in the “real world” would probably be MORE than I have figured. (I used the calculator located here to figure loan payments.)