What you need to know before you buy a car the “traditional” way

In order to explain why purchasing a car from a seized car auction is such a good idea, I need to talk about why purchasing from a dealership is such a bad financial idea. The two largest reasons I hate the idea of buying a car from a dealership, or even from a private owner, are depreciation and interest. Depreciation is the annual amount of decline in value that your car suffers simply by existing and being owned; and interest is the amount of profit the bank makes on your car loan, or the portion of your monthly payments that does not go to paying down the principal balance of your car loan.

How much does depreciation affect the value of your car? Well, average depreciation is typically 15 to 20% per year, which means if you buy a new car from a dealer for $20,000 it could be worth as little as $12,800 after two years. With numbers like those, it’s easy to feel like you’re on the wrong end of a loaded weapon, but don’t worry just yet, it gets worse.

To truly understand the effect depreciation has on your checkbook you must take into consideration the payments you’ve been making on the vehicle. After two years of payments on a $20,000 auto loan (at 6.9% interest on a 48 month loan) you will have paid almost $11,500. That’s a hefty chunk of change. And what do you have to show for that $11,500 you’ve spent? About $2,100 of equity in your vehicle. The rest was sacrificed to depreciation.

But wait a minute, didn’t I say that the car cost $20,000 and you’ve made $11,500 in payments in two years? Doesn’t that mean there is only $8,500 left to pay off? So if the car is worth $12,800 doesn’t that mean I have closer to $4,300 of equity in the car? Yes, until you consider interest. After two years of payments you will have spent $2,200 on interest, so instead of having paid your principal down to $8,500, you’ve only paid it down to $10,700 (or, looking at it from the other direction, $11,500 left your checkbook and $2,200 of it disappeared, so only $9,300 went towards paying down your principal).

In case that didn’t hit you like a ton of bricks the first time, go back and read it again. I’ll admit, I was so shocked by how amazingly horrible the situation is that I had to go over the numbers a few times. But here’s the truth: two years, $11,500 spent, and only $2,100 to show for it. Man, that’s a lot of wasted money (approximately $9,400).

So, what is the solution? Well, there are three things you can do to save yourself from losing all of that money. The first, and unfortunately the least viable solution for most of us, is to pay cash for your car. That way you’re only fighting losses due to depreciation and not both depreciation and interest. What are the potential savings in this hypothetical situation? Roughly $2,200. However, if you can afford to pay cash for a $20,000 car, you’ve either lucked out somehow or you’ve been very good with your money already. In either case, you probably aren’t here reading my blog, so I’ll assume that most of us are not going to be paying cash for a car.

The second solution is to buy a car that will depreciate less. If you purchase a car when it is two years old and sell it when it is four years old you’ll only lose about $4,600 to depreciation (keeping with our standard 20% depreciation hit every year). That’s still a lot of money, but it’s much better than $7,200. Many people don’t like this suggestion (my dad included) because they like the idea of driving a new car. They like the cleanliness, the prestige, and the new gadgetry, but most of all they like knowing that their odometer is still a long way from the dreaded 100,000 mile mark. I’ll admit, it’s nice to not have to worry about spending money on car repairs all the time. However, new cars are not totally immune to problems. That safe feeling you get from having less than 50,000 miles on your odometer is an illusion, but I’ll leave that for another day.

To finish proving my point about the financial benefit of buying a used car, if you make payments on a two year-old car (when the gadgets are still new and there is still plenty of life in the car) that you bought for $12,800, after two years you will have spent just over $7,300 on payments. A little less than $1,400 of that will have gone to interest, so you’ll have paid down your principal to roughly $6,900.  After four years of depreciation the car would be worth about $8,200, so you have about $1,300 of equity. In the end, if you bought a used car in this hypothetical situation you would lose $3,400 less over the two years you owned the car than you would if you bought it new (this is shown by the $2,600 depreciation difference and the $800 difference in interest).

I’m sure you noticed that in two years you’d have built up more equity by making payments on a new car than on a used car ($2,100 for the new car and $1,300 for the used car), but keep in mind that the difference in payments is almost $175 per month. So, if you were to make and extra $175 payment on your used car to make the total amount paid in the two situations equal, you’d have a lot more equity in the used car.

Maybe $3,400 isn’t enough of a big deal to you to pass up the prestige of a new car. Well, what if I could show you a way to dramatically increase the amount that you’d save over buying new? What if we could double that? Or triple it? Would you be interested in buying used then? I know I sure was.

Imagine, if you will, that you purchased the used car we talked about above for $8,800 instead of $12,800, which represents a 25% discount (an easy discount to come across at a seized car auction).  After two years you would have $3,500 in equity and you would have only lost $1,300 total ($1,000 to interest and $300 to depreciation). That’s a whole lot better than the $9,400 you’d lose to depreciation and interest if you bought the same car new.

I know it’s easier to go to a dealership, pick out a car, and drive it home. I’d do it all day long if I could. However, whenever I’m tempted to do things the easy way I remind myself that with a little more work I could save tons of money. It’s like being paid to buy your own car. In the above situation somebody got paid $8,100 to buy their own car through a seized car auction. If you really want to get crazy, figure out how much $8,100 would turn out to be in 40 years if invested in a decent mutual fund that paid a measly 10% return. It’s more than $400,000. Yes, that’s right, I just said that if you purchase a car through a seized car or government auction you could literally be saving yourself almost half a million dollars (how’s that for insightful?). Even better, that’s just one car, and throughout your life you’ll probably purchase at least 10 different cars (even more if you get a new car every two years). Given how simple that was, it’s amazing to me that most people in this country retire into a life of poverty.