Last week I met a buddy of mine for a few beers. Over the course of several pints and wings, my friend informed me his car will be paid off next month. He bought a brand new car five years ago after graduating from college for approximately $30,000. Since then, his monthly payment was just over $500/month for the last 60 months! This does not include taxes, maintenance or insurance. By many accounted , the car is considered a practical four-door mid-size car and far from lavish. This entire discussion had my wheels spinning and I immediately started running numbers in my head (more on the numbers later).
You see, we both had older cars while in college. Both of our cars still had several years left in tank. In fact, I am still driving my now 18 year old junker but acknowledge that I will need a replacement in the near future. Between 18 years and almost 200,000 miles, my car has seen better days.
The average price tag for a new car in the United States stands at $32,994 as of May 2016. According to a recent Experian report, the average auto loan is now $30,032, which is the highest level in history. The average monthly payment and loan term are $503 and 68 months, respectively. Both of these figures are also record highs. As a result, Americans are paying MORE every month for a LONGER period of time. That new car smell must be really worth it… NOT! This is a recipe for disaster, especially since cars are depreciating assets (lose their value over time).
Over the past several decades the automotive industry experienced a wave of innovation. Automobiles are more durable and high tech than 30 or 40 years ago. The average life expectancy of a modern car is approximately 200,000 miles and the average American drives between 12,000-15,000 miles year. Based off these numbers, the longevity of an average car driven by an average person is between 13 and 17 years. (200,000 miles / 15,000 miles = 13.3333 years; 200,000 miles / 12,000 miles = 16.6666 years)
Now… back to the numbers. Let’s just assume my friend’s ONLY car related expenses were his $500/month loan payment (not true, several other costs associated). This equates to $6,000 in annual loan payments ($500 x 12 months = $6,000) and $30,000 in total payments ($6,000 x 5 years = $30,000).
Now lets imagine if my friend invested $6,000/year for the past five years instead of paying for a depreciating asset. Assuming he earned an 8% return annually by investing in a low cost index fund or other forms of passive income, which is a modest assumption over a long period of time, his new car purchase would have cost him over $240,000 (see table below).
I was shocked when my buddy mentioned his intensions to buy another NEW CAR in the next year or two. His car is only five years old and has less than 60,000 miles. Conservatively, his current car has eight to ten years of useful life left. From a financial standpoint, my friend would be well served continuing to drive his car for the foreseeable future. Purchasing another new car would push his retirement back over $785,000 before he turns 60 years old (see table below).
Note: this friend does not buy into FIRE and believes he will work well into his 60s or 70s. With financial choices like this, its not surprising he thinks such a thing.
Buying a used car provides a worthy alternative for anyone in need of a ‘new’ car. Purchasing a car that is two to four years old, has been well maintained and has low milage, provides a great value. By doing so, you allow someone else to deal with the depreciation. Also, you can typically buy this type of used car between 30-40% of the original costs. This approach to car buying will save someone several hundred thousands of dollars over the course of their lifetime.
As previously mentioned, I plan on buying a used car to replace my old junker in the next year or two. I will seek a car that is two to five years old that has relatively low milage. Additionally, I plan to pay for this car in cash to avoid having a pesky car payment.
A while back, I set up a bank account to save for my future car purchase. I funded this account by directly depositing $100 every pay period. Additionally, I never carried the debit card for this to account; this helps avoid the temptation to raid the account for frivolous expenses.
Let’s assume in two years I buy a used car that is similar to my friend’s $30,000 car at 40% of the original cost. This used car would cost me approximately $12,000 ($30,000 * 40% = $12,000).
Let’s also assume that I will be paying all cash upfront. By deferring this purchase I benefitted by saving/investing $6,000/year for six years, which my friend did not. Additionally, I did not go and buy a brand new car (again) which lowered my overall out of pocket expenses ($30,000 vs $12,000). The table below shows my savings and what I lose when buying the car.
My friend’s decision to buy a new car cost him $240,000 by buying a new car after college. Over the same course of time, my decision to defer a car purchase and to buy a used car saved me $208,000; this is a difference of $448,000. If he buys another new car in a year or two (hope he does not) the difference will be greater than $1 million.
In conclusion, buying a new car costs several times more than the sticker price suggests. Cars are getting more and more expensive every year and there are several hidden costs associated with owning a car such as maintenance, taxes and insurance. My friend’s $30,000 purchase cost him $240,000 while my deferred purchase of a used car saved me $193,000. Purchasing a slightly used car provides a finically savvy alternative for anyone needing a ‘new’ car. What are your thoughts on purchasing a car? Does this analysis make you reconsider your future plans?