The average American owns 13 cars in his or her lifetime, at a current average cost of $30,000 per car. One of the easiest ways to save money is to buy an inexpensive car, preferably used. When making a decision about what kind of car to buy, it's important to consider your options and choose the one that makes the most financial sense for your situation.
My first car was a very sporty light blue metallic 1977 Datsun 280Z. Even though I inherited it from my dad after he had put 170,000 miles on it over 10 years, it still moved. I’ve loved fast cars ever since. However, fast cars are rarely cheap. I am now in the process of buying a new car. As I am thinking through the decision of whether to buy a new car or a used car, i've been asking myself the following - questions that my clients frequently ask me when they are considering purchasing a car. (For related reading, see: The Complete Guide to Buying a New Car.)
Question 1: New or Used?
With technology playing an ever larger role in the car buying decision, the idea of getting a new car with all the latest bells and whistles - particularly the safety related features - is pretty attractive. So is the thought of getting exactly the car we want along with a longer warranty and likely lower maintenance costs. Some people purchase new cars because they can put less down, but (and this is the financial advisor talking here) that’s a poor reason to buy new versus used. It’s a telltale sign you’re buying more car than you can afford.
The biggest downside to buying a new car is depreciation. On average, a new car depreciates a bit under 10% just in driving off the lot and the total depreciation figure roughly doubles in the first year. So the car you just bought for $40,000 is worth $36,000 once you sign the purchase agreement and in a year it is worth $32,000. Once you add in the cost of gas, maintenance and interest if you financed the purchase the cost of the car really adds up. Still, as someone who really likes cars and technology, I can understand the need to buy a nice, new car. And while I’ve long been a proponent of spending money on experiences over things, driving is an experience that is dependent upon the car. So, we’re leaning towards a new car.
Question 2: How Much Can You Afford?
When it comes to affordability, I want to make sure the cost of a car won’t leave us with too little cushion in our cash flow or keep us from hitting our savings goals. We have a budget in place, so the analysis is straightforward. If I needed to reallocate some spending to the car, I could. I’ll try to avoid this though, as I was just a little too impulsive in buying the last two cars I’ve purchased. If I don’t, I could well end up with a Tesla. (For more, see: Car Shopping: New or Used? )
Question 3: Lease or Purchase?
Now that we know we want a new car and we know what we can afford, we have the option of leasing or purchasing. Leasing a car would offer a couple advantages. The primary advantage is the ability to offload depreciation risk to the dealer. To understand how this works, consider buying a large SUV with poor gas mileage. One of the factors in determining the lease price is the residual value, which is the value the dealer estimates the vehicle will be worth at the end of the lease. To come up with this value, the dealer estimates the amount the vehicle will depreciate over the term of the lease. All else equal, the greater the depreciation, the higher your lease payment will be.
Demand and prices for fuel inefficient vehicles drop when gas prices rise. So in this case, if gas prices have risen a good bit as your lease term ends, the vehicle will probably be worth less than the residual value the dealer estimated at the beginning of the lease. In this instance, you benefit in two ways. First, your lease payment was lower than it would have been had the dealer used a correct, lower residual value. Second, you can simply turn the car in instead of buying out the lease by paying the residual value, since the residual value is higher than the car’s actual value.
While being able to offload depreciation risk to the dealer is an advantage of leasing, there are a few disadvantages. First, if you continually lease your cars, you will always have a car payment. Second, leasing cars over the long term often costs more than buying a new car (and a good deal more than buying a used car) as this article from Edmonds shows. Additionally, leasing a car typically isn’t a good option if you drive a good bit, as there are mileage restrictions on most leases and exceeding those restrictions can lead to a big bill at the end of the lease.
Finally, if you tend to keep your cars for a number of years as we do, leasing isn’t a good fit. For all the reasons above, we’ll likely be buying a new car outright as opposed to leasing it. Still, if you decide to lease, you can negotiate a lease just as you can a car purchase.
The Bottom Line
Buying a car is a major purchase. Answering the above questions will help you decide whether to buy new or used, how much you can afford or if you should lease instead of purchasing. (For more, see: 10 Tips for Buying a Car Online.)