My friend Larry recently asked me a good question that led to a challenging question: “Joe, isn’t it true that everyone needs to be putting aside money every month for a car fund?”
Joe, “Well, yes. Although some may be wealthy enough to have a nest egg generating vehicle purchase money, the vast majority of us need to be constantly saving for our next car purchase.”
Larry, “I know you are big about saving for car purchases. But I have been able to get a zero percent loan on the last couple of new cars I bought, so what is the difference in borrowing at zero percent and saving up to pay cash?” (That was the challenging question)
I admit that Larry caught me off guard. He is a sharp guy who would immediately challenge any noble idealism I might purport about debt being bad. He needed objective rationale.
So, scrambling a bit, here was my response, “Larry, I have found that when I save and pay cash, I am much more selective about what I buy. That cash is something that I have worked and scrimped to save, so I shop very carefully. On the other hand, when I borrow money to buy a car, I don’t see the money come out of my account, so it just doesn’t seem as real. I will therefore pay more, buy newer and get more options. In short, I spend more when I borrow than I would paying cash.”
“Oh. I hadn’t thought of it that way.” Larry was slowly nodding his head. “That makes sense.”
So I suppose I was able to give a decent answer, but Larry’s question made me think. Are there other reasons not to borrow money for a new car, even at zero percent interest? I think there are. Here are some thoughts:
Depreciation
New cars depreciate faster than used cars. Yes, you get a new car guarantee and a new car smell, but you are paying for it. According to SafeCarGuide.com, “New cars lose an average of 20% of their value the instant they are driven away from the dealership. When coupled to the annual yearly depreciation of 7% to 12%, your first year’s loss is anywhere from 25% to 35%. That translates to a loss of $6,000 to $8,000 loss on a $22,500 new vehicle, or a $10,000 to $15,000 loss on a $40,000 one. And that is for a vehicle that is only driven the average of 13,500 miles. If you drive more than that, your depreciation will be greater (35% to 50% for the first year)”
I think you get the point. That zero percent loan is costing you between $500 and $1,000 a month in depreciation costs for the first year alone.
Risk
The zero percent loan could spellbind you into buying too much car. If life happens (injury, job lay off, etc.) and you can’t make your payments, Mr. Tow Truck will show up and get your car. You will still owe on the negative equity even if you no longer own the car. Zero interest sounds pretty hollow once repo man shows up.
May be paying more for car
You may well be paying for that zero interest loan via higher sale price. Yes, dealers are offering deals to move new cars, but they aren’t stupid. That same car might have sold at a lower price if the financing would have included some interest payment.
The cost of dealing with a dealer
New cars, of course, must be purchased from dealers, but that is part of the problem. For sake of discussion, I compared the Kelly Blue Book retail price of a 2007 Cadillac Escalade ESV, excellent condition, with the private party price of exactly the same vehicle. The retail price of $42,440 is $3,600 more than the private party price of $38,840. My point is that you pay a premium simply for buying from a dealer. You also pay more sales taxes in many states. For example, in Illinois (where I live) the taxes for that $42,440 vehicle purchased from a dealer are $2,652.50 compared to $1,500 if purchased from an individual.
Lost opportunity cost
Larry and I started this conversation by agreeing that everyone, whether they are making payment on a loan or saving to pay cash, needs to budget a set amount for vehicle purchases. Even at zero percent interest, the new car buyer is going to pay more per month than someone (like me) who saves up and pays cash. How much is this difference and what could that money be doing if it weren’t going for cars? This number will vary greatly from person to person, but if we assume a $25,000 new car every five years compared to a $10,000 used car every five years, and factor in depreciation for each, the new car buyer will pay about $220 a month more. The lost opportunity, if invested at 8% annual growth for 40 years, is $768,000 dollars! How many of us could use that much extra cushion in our retirement portfolios?
Concluding thoughts
While a zero percent loan on a new car sounds good, there are many downsides. If the owner buys a new car just to get that zero percent loan, he is probably buying more car than he would by saving and paying cash. Even though he isn’t paying any interest, he is paying for depreciation, sometimes as much as $1,000 a month for the first year. Other downsides are risk and the higher costs of purchasing from a dealer. In addition, the lost opportunity cost can be substantial over a lifetime.
According to “The Millionaire Next Door” by Stanley and Danko, 76.5% of millionaires buy used cars instead of new.
Hmmm. Maybe that is how they became millionaires.
How do you plan for car purchases? Do you save and pay cash or do you borrow? What have you found to work best for you?
This post was included in the Carnival of Personal Finance hosted by Amateur Asset Allocator
It was also included in The Best of the Best in Money and Personal Finance hosted by Len Penzo dot Com
{ 1 trackback }
{ 11 comments… read them below or add one }
We just bought a used car and some of it is financed with a 0% interest loan. If I had cash only- I could have knocked another $250-500 off the price (dealer even said so).
We were in a bind with out car dying and not enough money to repaid the car (engine!!) but enough trade value and cash to get a suitable replacement. So the 0% interest loan helped us get a more reliable and better car for our needs.
Paying in cash = better bargaining power.
Ted @broketofree´s last blog ..Getting used to being in debt…
Our last couple of cars we’ve saved up and paid cash for. It’s amazing how much better a paid for car will drive – or at least I feel better driving it!
Because we were paying cash we were much more selective about what we bought, did a lot more research, and when the right car came around we were able to go out and pay cash for it. Now we’re paying ourselves payments again for our next car!
Peter´s last blog ..3 Things To Remember About Roth IRAs
@Ted,
Even with your misfortune…engine! aarrgghh!… you still discovered that cash is the way to go. Your words: paying in cash = better bargaining power are even more true when buying from an individual instead of a dealer. My hunch is that you will get yourself to the point of paying cash for your cars.
@Peter,
You brought out the biggest advantage that one never really understands unless they actually pay cash for a car: being selective. With my last car purchase, I looked and looked and looked before I bought. I found exactly what I wanted on Craig’s list and have loved it ever since. And yes, it does drive better if it is not pulling a bank note behind it.
We’ve been saving up to buy me a car and I may have to wait a few more months to get it, maybe May or June, but it will be worth it! Not having to try to negotiate with a dealership is enough. I always feel pressured at the dealership!
lencib,
Awesome! As we have been saying, cash will give you the best buy AND the best peace of mind. Correct me if I am wrong, but it seems to me that I remember reading about your car considerations on your blog. I am glad you decided not to buy new.
Joe,
I’ve got a post coming up at Christianpf that is going to share more of my thought on this, but in my case I decided that I’m going to pay cash for cars. Because of my salary that means buying less expensive vehicles. Even at 0% I don’t think I could afford the payments on a new car.
I’ve found that I get the best deals on cars from individuals. Last I checked people don’t offer 0%.
Craig Ford´s last blog ..5 Lies of Efficiency and Productivity
Craig,
Dealing with individuals has worked well for me. The main reason is that the dealer has an absolute bottom line: he HAS to get a certain price in order to make a living. Individuals, on the other hand, are normally selling simply to get rid of the car, which gives the buyer more negotiating room. Besides, I just like dealing with individuals.
Cash is the way to go. Obviously for you to get a near new car and pay up cash will require alot of savings.
We will be replacing my 93 honda sometimes this summer and we are saving up for it – whatever the car we settle for, we will par cash for it. No more car notes for us. They can keep the zero percent.
Joseph | Kickdebtoff´s last blog ..Some DIY Savings Tips
Joseph,
Isn’t saving to pay cash a great feeling? You are not falling for the “gotta have it now” mindset that is so prevalent in our culture.
My wife and I are currently saving up to replace her ‘96 Aurora this fall. We won’t be buying any thing close to a new car, but used cars in the $10,000 range have served us well. Like you said: no car notes. They can keep the zero percent.
Joe, great post. Good reasons for paying cash. Haggai 1:1-11 tells us to carefully consider our ways. Using our hard earned cash definitely makes us more selective and more considerate of each purchase.
To be honest, I struggle with some things. This is one of them. I struggle with the depreciation argument and used car preference. I don’t buy a car with the intention of selling it within a year or even ten years. So what if the “value” of the car drops quickly if I don’t intend to trade it in? I know people who trade in their car every three years. Doesn’t make sense to me!
For me the purchase price of a new car makes sense if I know I will use the car until the wheels fall off! Purchasing a $25K new car that should last ten – fifteen years makes sense to me compared to purchasing a $10K used car that may last five – ten years with the risk of increased maintenance.
I guess I look at it a different way. If you have to have transportation that is going to depreciate in value, why not minimize the number of purchases made over your lifetime by purchasing good reliable new cars?
Just my thoughts. Very interested in hearing yours.
Cedric
Cedric,
As always, I appreciate your thoughts. We definitely agree that whether you purchase new or used, PAY CASH! I also agree that IF you are going to buy a new car, you should definitely drive it till the wheels fall off, as you suggested.
Still, the depreciation on a new car is huge. If the depreciation is 40% the first two years, that $25,000 new car could be purchased for $15,000 when it is two years old. It makes more sense to me to buy a two year old car and let some one else take that depreciation hit. That is what most millionaires do.
Stated another way, that new car is going to be a two year old used car in two years, so I would rather pay $15,000 to drive the two year old car 13 years than $25,000 to drive a new one 15 years. But maybe that is just me.
Yes, the used car could have more maintenance concerns, but Toyota has been teaching us that new cars can have problems too. I try to find cars that may have a few more years, but low mileage…and I have had very few repair issues with the used cars I have purchased. But, like I said, I have been VERY selective.
In a way, we are splitting hairs. The main thing is to pay cash and, if you buy a new car, drive it a long time. We both agree on those points.