If you’ve watched a TV or streamed a video at any point since Thanksgiving, you are keenly aware that it’s the annual holiday BIG BLOWOUT ONCE-IN-A-LIFETIME SALE AT [Your Local Dealership]. Pick your auto brand, and apparently, there has never been a better time to buy your spouse a luxury sedan or truck with a big red bow on it that they can be surprised by in the driveway Christmas morning (Pro tip: Don’t do this.)
But it raises the question of the practical realities of car buying and how you might want to approach that activity, whether it be for the holidays or just because you’re in the market for a daily driver. So this week, we’re talking about the practicalities of car shopping and some things to consider as you go about it.
Practical Driver or Lifestyle Choice?
There’s no inherently right or wrong answer to whether you want to buy a metal box on wheels that gets you from one place to another, or whether you want your personal vehicle to make a statement or otherwise be an expression of your great life. The only thing that matters in that decision is fundamentally whether it’s affordable to you or not. So, on the assumption that you can afford it, there are a couple of baseline considerations for buying a car.
If you are looking for a practical driver, you’re most likely going to benefit from looking for a moderately used sedan, typically with less than 30,000 miles on it, which is probably 2-4 years old and used; ideal brands with the best longevity tend to be Honda and Toyota, but you can find a decent car of any make or model based on your personal preference. The main point in looking for this practical driver is that you’re buying something that has had its major “used car” depreciation discount applied to the vehicle’s cost, but it hasn’t been driven aggressively. While there’s an argument for buying a car with 200,000 miles for less than $1,000, you’ll likely find that you’re spending more than $1,000 on repairs within a year after purchasing it. Alternatively, spending between $10,000-$15,000 for a vehicle that won’t need a major service for 2-3 years is going to give you less of a headache hassle and a bit more reliability out of the gate.
If you’re looking for a lifestyle purchase (for example, a good friend of mine has a Porsche Macan named “Blueberry”), then there’s less practical consideration in minimizing cost to maximize benefit. While luxury vehicle values drop off a cliff the moment you start the engine after you’ve signed the paperwork, you don’t buy a luxury vehicle as a financial decision because you inherently know it’s not a “good” financial decision. You buy it as an extension of your lifestyle. Or, as my friend puts it: “I love driving that thing every day.”
Buying vs. Leasing
The basic math behind whether you want to buy or lease is seldom financially driven so much as a question of timeline. We instinctively know that a lease is cheaper up front and more expensive long term because we are just renting the vehicle, not building up any equity or ownership that eventually stops our payments. In turn, we know that buying a car is more expensive because we are taking ownership, but long-term, it will be cheaper than leasing an equivalent vehicle. There is some debate and disagreement about the convenience and practicalities of leasing vs buying, e.g., not having to deal with major repairs down the road. But functionally, the break-even on a vehicle purchase versus a leasing decision is typically going to hit around the 5-year mark, or roughly in alignment with the end of a 5 or 6-year auto loan, as the case may be.
A couple of practical considerations on the side of leasing include the potential costs of mileage limits and contractual requirements for regular service. If you’re a fairly busy person, one of the perks of leasing can be that you don’t have to deal with major services. The downside is that you’re going to be compelled to bring the vehicle in for regularly scheduled checks, or otherwise face financial penalties. Another issue, if you’re a heavy driver, can be the cost of “excess miles,” in which you pay a per-mile penalty for driving your vehicle farther than permitted in the contract.
In turn, the calculus on auto loans isn’t as easy as it was a few years ago. Through most of the teens and in the early twenties of this century, interest rates were so low on auto loans that it was almost free money to finance the purchase of a vehicle. Today, auto rates are frequently in par with expected average market returns and are far in excess of commensurate high-yield or CD rates at the bank. Thus, while 0% down 0% interest offers were very common over the past decade, today they’re a little less common (though not entirely gone!) Keep in mind that there is no free lunch; if the financing rate is essentially zero, you can guarantee that the profit margin of a loan is just baked into the sale price. “There is no free lunch,” as they say.
Fees and Costs of Insurance
An invisible or often unanticipated cost of purchasing or leasing a car is going to be the taxes, fees, and insurance. Colorado, in particular, charges higher vehicle registration fees for both newer and more expensive vehicles. While my 2015 Prius only costs $95/year before another $20 or $30 in ticky-tacky “extra” fees, a client’s recent BMW purchase saw them paying almost $1,000 for the auto registration alone.
In turn, insurance will be a sticking point. As with auto registration costs, you’ll typically see higher costs for insurance on both new vehicles and more expensive vehicles relative to older models. A key consideration here is whether you’ve paid cash, taken out a loan, or are leasing. In the case that you’re leasing or took a loan out to buy, you are required to have comprehensive and collision coverage on your vehicle. This specifically covers repairs, damage, or loss to your vehicle and often makes up half, if not more, of the premium on an auto policy. However, if you’ve paid cash, you might choose to approach this differently depending on the vehicle’s value.
When a vehicle has no lien against it, you’re not required to have comprehensive and collision coverage. That doesn’t mean you don’t want it, particularly if you paid cash for a new vehicle or otherwise purchased something nicer or more valuable. But if you purchased the aforementioned “metal box on wheels” for only a few thousand dollars, then spending an extra several hundred or thousand dollars a year to get it replaced, plus a deductible of another several hundred or thousand dollars, might mean that you’re paying for insurance that’s effectively worthless to you based on the vehicle you’re driving. Not to worry, though, the insurance company will happily take your premium dollars and hand them back to you at a discount if something happens!
How Much Can I Afford When Car Shopping?
Simply put, it’s recommended that the debt or lease payments for a vehicle don’t exceed 10% of your gross income. That number can seem big or small, but I encourage you to add in the monthly average licensing fees and insurance costs into that calculation to really dial it in. For example, if you make $120,000 a year, $1,000/month might seem perfectly adequate for a car payment. But if you purchase a $40,000 vehicle at a 6% interest rate on a 5-year term, your monthly payment is going to be $773.31. Throw on $100-$200 a month in auto insurance and another $50-$100 in registration fees (taking an annual figure and dividing it into monthly increments), and you’ve possibly already blown through your $1,000 of affordability.
Some recommendations you’ll find out there are to go in with a larger down payment and then reduce the duration of the loan to try to reduce the net cost. While these are good for financial optimization long term (e.g., reducing the cost of borrowing capital), they can exacerbate the actual cost of the monthly payment, since shortening the duration requires that more significant payments against principal be made. Fundamentally, the core question should be whether we’re looking for the practical driver or the lifestyle purchase. If the vehicle is genuinely a practical driver, then buying cheaper, making a larger down payment, and reducing the term of any loan is going to help with the financial optimization of the purchase. If the purchase is a lifestyle decision, then you may want to accept a longer-term loan and a lower down payment to increase the lifestyle side of the equation, even if it comes at a greater financial cost.
Ultimately, whether you decide to lease or buy, be frugal or go for luxury, or otherwise make financial decisions around your car of choice, just keep in mind that cars are seldom financial assets. While trucks and certain types of vans can maintain decent value due to their long-lasting design and utility for both personal and work purposes, most sedans, coupes, and SUVs do not maintain value as assets. So, while all this discussion and consideration of financial optimization are important to keep in mind, don’t ever fool yourself into thinking you’re going to get a substantial return on investment for a vehicle. Frame your decision around your practical needs, whether it’s just a means of transportation, or whether you’d like to use your vehicle as a means of spending on your personal quality of life.