Car ownership isn’t an investment, it’s a cost. With few exceptions, cars generally depreciate in value at a rate of about 15%-20% per year. So in financial terms, your return on investment is always going to be negative. But that doesn’t mean you don’t need (or shouldn’t have) a car. It’s just that the financial implications of vehicle ownership means the more valuable your automobile(s), the more value you lose year to year. So those who learn to live with less, more often than not, will get the best bang for their auto buck.
But perhaps a more pressing concern for most consumers isn’t even the economics of owning, but rather the economics of financing a car. The first step to making your money go farthest when it comes to your automotive purchase is understanding and limiting the costs associated with the different financing options.
So in this article we’ll first explore the (purely financial) economics of the different ways to finance your next vehicle. Then, we’ll outline a realistic long term plan, that anyone can follow, that will allow you to pay cash for every vehicle you buy for the rest of your life.
Leasing vs. Buying
Leasing is appealing to consumers who want to drive a newer car for lower monthly payments than they would require to purchase the same vehicle. Because of this, on the surface, it seems that leasing is less expensive. But the reality is it’s almost always going to end up being more expensive.
When you lease a car, you pay the owner/dealer directly for the car’s value depreciation plus interest (on the car’s value). That’s the majority of what’s built into the monthly payments. At the end of the lease term, you will own nothing nor will you have any equity in said car.
Buying, by comparison, you pay for the value of the car directly, and after the car (loan) has been paid off, you own the car (and its remaining value) outright. In theory, leasing a car for 4 years will cost you the same as financing the purchase of that car on a 4 year loan (at the same interest rate as the lease), then selling the car at it’s remaining value. Simplified, it will look something like this:
Car = $20,000 (including tax) | Interest = 4% APR
Lease: $250/month * 48 months = $12,000 (total cost of leasing)
Loan: $450/month * 48 months = $21,600 (total cost of auto loan) – $9,600 (remaining car value) = $12,000 (net cost of financing after 4 years)
What makes the lease option more expensive is what happens at the end of the 4 year term. The leaser has two options: either begin a new lease, or purchase the car from the dealer. Purchasing the car then will always be more expensive than purchasing the car from the get-go. Starting a new lease, however, even though you’ll be driving a brand new vehicle, you’ll continue to pay the high rate of value depreciation and interest on a new car. Meanwhile, the person who took out the loan now has no monthly payments to make and only loses value in their car, but at a slower rate than when the car was new. After another 4 years (8 total), it will look something like this:
After 8 years
Lease: $24,000 (total payments) / 96 months = $250/month (net cost to lease)
Loan: $21,600 (total cost of auto loan) – $4750 (approx. remaining car value) = $16850 / 96 months = $175/month (net cost to finance)
The lesson here: the longer you plan to own your car, the more clear the financial benefits of buying (vs. leasing) becomes.
Cash vs. Loans
Paying cash for a car is obviously preferable over taking out an auto loan because you don’t have to pay interest. But most people simply don’t have that much cash laying around, so they opt for the loan, particularly for their first car. And while there’s nothing wrong with doing this, what most people fail to do is take advantage of the time after they finished making payments and own the car outright. If you continue to save money during this time, you may even be able to pay cash for your next car. Here’s how:
Let’s continue using the above example and say you opted to finance the car and plan to own it for at least 8 years. After paying $450/month for 4 years, you own the car outright. For the next 4 years, however, instead of making car payments, you instead save $350/month (note: less than loan payments) into a savings account (earning interest). So after 8 years, not only do you own the car free and clear, but you’ll have saved a significant amount of money for your next car:
Saving for 4 years after the loan is paid off
$350 * 48 months = $16,800 (cash) + $4750 (value of car) = $21,550 (towards your next car)
Keep up the momentum
Now that you’ve paid cash for a brand new car, you’re done, right? Wrong. Why stop there? Continue to save money each month to put away for your next vehicle so you never have to pay interest on another car again. What’s more, the car you now have, you don’t have to make payments for in the first four years. You can even reduce the amount you save each month because in 4 years, the value of your car will be double what it would be in 8.
Saving for your next car:
$220 * 48 months = $10,560 (cash) + $9,600 (value of car after 4 years) = $20,160
In other words, with this plan, it’s possible to buy a brand new $20,000 car, every 4 years, with cash, for an overall monthly cost less than leasing!
It works for used cars too
Buying a brand new car is generally thought of as a poor financial purchase. Most frugal experts will tell you that buying a used car (even 2 years old) is a much more sound decision. At a relatively conservative 15% depreciation, your $20,000 new car will lose over $5500 in value the first two years. Meaning you could have bought this same car for around $14,450 2 years pre-owned. Suddenly our saving schedule becomes even easier:
Saving for a pre-owned car:
$145 * 48 months = $6960 + $7,540 (value of the car after 6 years) = $14,500
How far can you take it?
If you wanted to save even more money on your vehicles, all you need to do is hold on to them longer. The longer you wait to buy your next car, the less you need to save each month:
2 year old Pre-owned car over 6 years:
$125 * 72 months = $9050 + $5,450 (value of the car after 8 years) = $14,500