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New Cars Can Be Costly!

by | Apr 9, 2018 | Budgeting

Unless you live in a city, owning a car is almost as essential as having a place to live. In fact, buying a car is normally the second biggest expense we incur in our lifetimes behind buying a home. Many of us – myself included back in the day – love the idea of getting a brand new car. It smells great, no one else has ever driven it, and it has all the latest technologies. However, spending too much on cars can be costly in ways we cannot see, as we will explore below.

Depreciation Downer

One of the “hidden” costs of car ownership is depreciation. This basically means that your car loses value every week that you own it. It gets older, it gets used and gets dinged up. According to industry sources and laid out by CarFax here, the typical new car loses 10% of its value after you drive it off the lot. Even worse, it loses another 10% for the rest of the first year, bringing total first year depreciation to nearly 20% of the car’s original value. After that, depreciation rates slow somewhat to about 15% per year. To illustrate this, a car costing $32,000 today will be worth $21,760 in two years, losing about one-third of its value in the first two years alone as shown in the graph below.

Now, there’s nothing necessarily wrong with depreciation. It’s just a fact of life that you cannot avoid if you want to own a car. Much like our computers, cell phones, and other technological devices, the times change and the “new” is always going to be worth more than the old. That said, we can be smart about how much of that depreciation we are willing to absorb, as that “lost” money must come from somewhere.

Opportunity Cost Comes-A-Knockin’

If you’ve ever taken an economics course you’ve probably heard of the concept of ‘opportunity cost.’ Basically what it means is that you have a choice to do one thing or another, but not both. For example, if you had $1000 laying around you could decide to take the family on vacation or remodel your bathroom. If you choose to take the vacation, you’re going to come home to the same old bathroom that needs to be remodeled, but you no longer have $1000 in the bank to pay for it.

Your car buying choices also present opportunity costs. Spend too much on a car, and you have less money available for other things like vacations or saving for retirement.

Let’s Look at an Example

In the example below, we are going to look at two people: Buyer A and Buyer B. Buyer A loves getting a brand new car every 5 years. Buyer B, on the other hand, hates depreciation and instead opts to buy a 2 year-old used car every 5 years. They do this from the time they are in their 20’s until they retire at age 65. All told, these two people have purchased and sold eight cars during their adult lives.

Let’s make some assumptions:

  • Cost of a brand new car today: $32,000
  • Annual increase in the price of a new car: +2%
  • Interest rate on car loan: 4.5%
  • Length of car loan: 5 years (60 months)
  • Depreciation in 1st year: -20%
  • Depreciation per year in years 2-5: -15%
  • Investment returns: +8.0% (see disclaimer here)

One other note about Buyer B: she is aware of the cost difference between getting a new and used car and knows she will save money every month by getting a used car. So with that in mind, she decides that she will invest the difference between the cost of getting a used vs. new car into her retirement account. Let’s see how she fares.

A couple of observations:

1) Because Buyer A is choosing to buy a new car instead of a used one, on average Buyer A will have a monthly payment ~60% higher than Buyer B, who bought the same car but as a two-year-old used car

2) Importantly, the money that Buyer B saved on her monthly car payment – which was stashed away in her retirement fund – has grown to nearly $600,000 in 40 years! That’s not likely to be enough to fully fund her retirement, but it certainly helps her get close to her retirement funding goal.

Wrapping Up

The point of this exercise is to demonstrate how one simple, smart choice about our car buying habits can reap huge rewards over the long-term.

Whenever we make big financial decisions, it’s important to consider what the “hidden” cost of those decisions are. Oftentimes, it’s only after we make a big purchase that we find ourselves feeling trapped or strangled by the resulting debt payments. In these cases, the “cost” of buying too much home or too-expensive of cars can result in families sacrificing saving for their children’s college education or even their own retirement. Be smart before making that big purchase!

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