Monday , 23 October 2017


The $1 Million Decision: Buy A Used Car Or Buy A New Car

…Buying a new car doesn’t make much sense when you look at it from acars financial perspective. Frankly, you could come out $1 million dollars ahead driving used instead of buying new over a span of 40 years. Yes, over $1 million dollars!

The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article written by Dr Penny Pincher (WiseBread.com)

When you buy a new car, there are several financial factors working against you.

  1. First, the asset you are buying — the car — depreciates rapidly. As soon as you drive it off the lot, it is worth thousands less than what you paid. In about four years, a new car will typically be worth half its original value.
  2. Secondly, when you make car payments, you are paying interest. So not only are you putting money into an asset that is certain to depreciate, you are borrowing money and paying compound interest as well.
  3. Finally, there is the opportunity cost (i.e. return of most lucrative option – return of chosen option). This is a factor many people forget about. Put simply, opportunity cost is what you give up by choosing one investment or purchase over another.
    • Instead of spending money on a depreciating asset, you could invest the money instead where it would likely grow.
    • Over a lifetime, this could add up to a significant amount of money.

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New car versus used car scenarios

In many parts of the United States, it’s impossible to get to your job or other places you need to go without a car. I’m not suggesting you have to completely give up automobiles but there is a big difference between always buying a brand-new car, and buying used, and when you consider that you could be investing that price differential in a growing stock market, the argument for used cars becomes hard to ignore.

I’ll run through some scenarios to analyze the opportunity cost of making new car payments, considering how much you could end up with if you choose to invest the money instead where it could grow rather than depreciate.

For the opportunity cost, the analysis assumes that over the long term you could realize an 8% rate of return from stock market investments. Of course, no one knows how the stock market will perform in the future, but an 8% rate of growth is often used as a long-term average that includes both boom and bust cycles. The goal of this analysis is to provide a general idea of the potential magnitude of making car payments instead of investing the money.

The scenarios for buying new cars versus driving used cars will run for 40 years to represent a lifetime of car buying behavior. Note that the effect of inflation on the price of the car or on potential investment value is not included in the analysis.

Now, let’s find out how much you could save by driving a used car.

Scenario 1: That new car smell!

First, let’s look at a scenario where you always drive a new car.

We’ll assume:

  • you buy a brand-new car for $35,000 every 4 years
  • with a 48-month financing plan
  • that charges 0.9 percent interest.
  • You make payments for four years, and then trade it in for its depreciated value (we’ll use $17,000),
  • and the trade-in value is applied toward the purchase of your next new $35,000 car.

In this scenario, you are always making payments on a new car.

Using the Calc XML car loan calculator, we find that the monthly car payment:

  • for the first four years is $743,
  • then it’s $382/month for the following 36 years when we’re able to take advantage of the $17,000 trade in every four years.

Adding up those payments we get (743 x 48) + (382 x 432) = $35,664 + $165,024 = $200,668.

Now, let’s calculate the opportunity cost of making those new car payments for 40 years. We’ll use an investment calculator from CalcXML.

Assuming annual compounding, with a start amount of $0, an annual interest rate of 8%, and an annual deposit of $8,916 (those monthly $743 car payments x 12), we get a future value of $43,391. That’s the amount we could have made if we’d foregone our first four years of new car payments and instead invested that money in the stock market.

After those first four years, the amount of our car payments, and thus the opportunity cost of investing them, will be lower ($382 per month, or $4,584 per year) because we’ll be getting a $17,000 trade-in for our old car. We’ll start with investing the $43,391 we earned in the first four years, and after 36 years of such contributions, we end up with a balance of $1,619,165. This amount represents the opportunity cost of making new car payments for 40 years. That’s how much we’re losing out on stock market gains by burning our money up on new car payments!

Results over 40 years:

  • Total cost of car payments: $200,668
  • Total return: $0
  • Total invested (if we skipped the car altogether): $200,668
  • Total returned: $1,619,165
  • Opportunity cost: $1,619,165 – $0 = $1,619,165.

If you invested instead of making car payments, the opportunity cost of always driving a new car is: $1,619,165.

Scenario 2: Drive it ’till it drops!

Next, let’s consider the other extreme. In this scenario, you never make car loan payments.

Let’s assume:

  • you take a frugal approach to buying older used cars, and budget only $600 per year for purchasing the next car. With this budget, you could afford to buy a $6,000 used car every 10 years to meet your transportation needs — with no finance charges involved.
  • Also, a budget of $100 per month for maintenance and repairs is included in the analysis, since you will always be driving an older car in this scenario.

As I mentioned, this is a frugal scenario. You’ll need to save up your $150 per month total car budget until you have enough to pay cash for a used car.

Again, to calculate the opportunity cost, we’ll consider investing $1,800 a year ($600/year + $100 maintenance fees x 12 months) for 40 years with interest compounded annually.

Results over 40 years:

  • Total cost of car expenses: $72,000
  • If you invested your car expenses instead, the opportunity cost of driving a cheap used car is: $503,607
  • Opportunity cost benefit over always driving a new car: $1,115,558 ($1,619,165 – $503,607)

Since the opportunity cost of driving a new car all the time is around $1.6 million, by buying a cheap used car and maintaining it for 40 years you come out ahead by more than $1.1 million (i.e., the opportunity cost of the used car is only about $500,000, which is $1.1 million less than the opportunity cost of always driving a new car).

In other words, if you only bought cheap used cars and invested the money you would have otherwise spent on new cars, you could make more than a million dollars in the stock market over 40 years.

Scenario 3: Buy a four-year-old car, drive it for 10 years

Let’s assume:

  • …you buy a four-year-old used car for $17,000,
  • pay it off in four years at 4.9 percent interest,
  • and then drive it for six more years with no payments
  • Since your car is more than four years old at all times, the analysis includes $100 per month for repairs and maintenance throughout the scenario.

If you buy a four-year-old car and drive it for 10 years, this means that you will be driving a 14-year-old car at times. If you have not driven a car this old before, you may be concerned about reliability, but I can say from experience that well-maintained cars will easily run this long.

Results over 40 years:

  • Total cost of car expenses: $103,872
  • If you invested instead, the opportunity cost of driving a nice used car is: $817,985
  • Opportunity cost benefit of driving a nice used car instead of always driving a new car: $801,180 ($1,619,165 – $817,985)

In other words, even if you bought a relatively nice used car every 10 years and invested the money you would have otherwise spent on new cars, you could still make more than $800,000 in the stock market over 40 years.

How much can you save driving used cars?

The results of these car buying scenarios over a 40-year period show that:

  • if you are willing to minimize your car payments by driving inexpensive used vehicles instead of new ones, you can come out ahead not only by saving on car expenses themselves, but by reducing the opportunity cost of your car payments by $1,115,558 — over a million dollars!
  • if you buy four-year-old cars instead of brand-new and drive them for 10 years, you can come out ahead by around $800,000 in opportunity cost compared with driving brand-new cars.

Conclusion

When you look at making a car payment of a few hundred dollars per month, it may not seem like a lot of money but, as you can see, financing new vehicles can add up to a lot of missed investment opportunity over time. This makes driving a used car instead of a new car seem like a relatively painless way to boost your retirement fund.

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