New vs Used Cars

Is buying a used car really all that important to your financial health?  I’ve seen lots of articles and posts that say that financially responsible people buy only used cars.  Being the data geek that I am, I was curious so looked into the question.  In this post, I’ll provide you with my insights on the importance of buying a new vs used cars.

Summary of Findings

Here are the important things I learned from studying this question.

  • The cost of your car is more important than whether it is new or used. For example, you will have more savings if you buy a new car for $15,000 than a used car for $20,000, assuming you own them for the same length of time.
  • How long you own your car can be more important than whether you buy a particular model when it is new or when it is three years old.
  • The accumulation of savings from buying less expensive cars and owning them longer, especially after the compounding benefit of investment returns, can be significant though not as large as the amounts I’ve seen reported by some other authors on this topic.

The chart at the very end of this post illustrates these points (so keep reading).

Cost of Buying A Car

How much you pay for a car depends on several factors – its make and model, how old it is, how many miles it has on it, whether it has been in an accident, among other things.  It also depends on how you pay for it – cash, lease or borrowing – as discussed in my post on that topic.  If one of your goals is to save as much as possible, you’ll want to buy the least expensive car that meets your needs, regardless of whether it is new or used.

The biggest argument against buying new vs used cars is that the value of the car decreases more per year when it is brand new than when it is older. This decrease in value is called depreciation.

Depreciation

The chart below illustrates estimates of the patterns of depreciation for five different makes and models – a Subaru Impreza, a Ford Fusion, a Toyota RAV4, a Ford F150 and a BMW M4.

These estimates are based on a combination of data from Edmunds and the National Automotive Dealers Association (NADA). These two data sources didn’t have always values that were consistent, so I applied some judgment in deriving these curves.

The graph shows that all five models depreciate between 18% (Impreza) and 29% (F150) in the first year.  In the next 10 years, depreciation is generally between 13% and 17% per year and is even lower when the cars are older than that.

Depreciation in Dollars

To look at these values from a different perspective, I created the next graph that shows the dollar amount of estimated depreciation each year.

This chart shows that, even though the Fusion has the second highest percentage depreciation in the first year, it has the smallest dollar depreciation.  When considering how much a car will cost you, it is the dollar depreciation that is important.

These graphs make it fairly clear that, if you plan to reduce the cost of a car purchase by buying used, you save the most money by buying a car when it is one year old. The amount you will save gets smaller with each additional year the car ages.

Costs of Owning a Car

In addition to depreciation and, if applicable, finance or lease costs, there are five other major costs of owning a car – fuel, insurance, taxes and fees, maintenance, and repairs.

Fuel

The cost of fuel (e.g, regular, premium or ethanol-free gas, diesel or electricity) will generally stay constant for each mile you drive, other than inflationary changes in fuel prices.  For modeling the total cost of ownership, I assumed you will drive the same number of miles every year so the real cost of fuel will be constant.  I used the first-year fuel cost from Edmunds True Cost to Own as the real cost of fuel in every year.

Insurance

The portion of insurance that covers liability will likely be constant for a particular car in real dollars.  The cost of liability insurance will be higher for makes and models of cars that are in more accidents (e.g., sporty ones) and larger cars (e.g., pick-ups that will cause more damage to another vehicle or more severe injuries).  For my analysis below, I have used the first-year insurance cost from Edmunds True Cost to Own.  I assumed that 40% of that amount was for liability insurance and would stay constant in real dollars.  That leaves the remaining 60% for physical damage coverage which I assumed would decrease, in real dollars, in proportion to the value of the car.

Taxes and Fees

Taxes and fees can be constant over time or decrease with the value of the car, depending on the state in which it is registered.  For my analysis below, I used the first-year amount for taxes and fees from the Edmunds True Cost to Own.  For subsequent years, I have assumed that taxes and fees, in real dollars, would decrease with the value of the car.

Maintenance

This component of the cost of owning a car includes regularly scheduled maintenance and parts replacement, such as oil and other fluid changes, tire rotation, balancing, alignments and replacement, brakes, transmissions, tune-ups and anything else included in the maintenance schedule provided by the dealer when new. It excludes repairs for damage to the car and repair or replacement of parts not on the schedule.

I have assumed that the real cost for maintenance is fairly constant per mile over the life of the car.  Because I am assuming that your annual mileage is fairly stable, I can assume that the real cost of maintenance is constant from year to year.

Warranties Reduce Maintenance Costs

The significant exception is that many manufacturers include the cost of up to five years of maintenance in the purchase price of a new car.  In my analysis below, I have relied on the information in the Edmunds True Cost to Own for the length of time that maintenance is covered by the manufacturer.  After that, I used the average maintenance cost for the remaining years included in the Edmunds data and assumed it was constant in real dollars for the rest of the life of the car.  I also assumed that the maintenance provided by the manufacturer is transferrable to a new owner.

If you are comparing the cost of a new car with that of a used car, you will want to make sure you understand which maintenance costs are covered by the warranty for each vehicle.  For most of the cars in this comparison, the average annual cost of scheduled maintenance was estimated by Edmunds to be between $750 and $1,150 a year.  The exception is the BMW for which the average annual cost after the warranty ends was closer to $3,000 a year.  The maintenance covered by the dealer could offset some of the higher depreciation you experience in the first few years of owning a new car.

Repairs

Repair costs include repair of damage to your car, such as cracked windshields, and repairs or replacement of parts that break.  For my analysis below, I used the repair costs provided by Edmunds for each of the first five years after the car is new.  I then looked at the results of a Consumers Report study to estimate how much repair costs would increase as the car got older.  Based on that study, I estimated that repair costs increased about 4% per year in real dollars.

Total

The graphs below show the components of the cost of ownership (excluding purchase price, financing cost and depreciation) for the five illustrative cars in each of the first and fifth years of ownership.

 

A comparison of these charts shows the much lower cost of owning a new car than a five-year old car if the costs related to its purchase are excluded.  While the insurance goes down from the first year to the fifth year, the cost of maintenance increases significantly as the manufacturer is no longer paying for it.  In addition, Edmunds shows no repair costs in the first year after it is first sold, but they can be significant, especially for the BMW M4, by the fifth year.

The chart below shows the total of these costs for each car by the number of years since it was new.

For most of these cars, the ownership cost is fairly constant starting in the second year. The Impreza, Rav 4 and Fusion all have annual ownership costs of about $3,500.  The F150 has a similar pattern, but its annual ownership cost is closer to $4,500.  The BMW M4 ownership cost is similar to that of the F150 for the first three years, but increases dramatically when BMW stops covering the costs of maintenance and repairs.

Total Cost of Ownership

To provide insights on the long-term costs of different car-buying decisions, I calculated the total cost (in real dollars, i.e., without adjustment for inflation) of owning a car assuming the same choice was made for 60 years.  I used 60 years as I thought it fairly closely represented the length of time people own cars – from the time they are about 20 until they are about 80.

In these comparisons, I included the initial purchase price of each car (using the new car costs from Edmunds and used car costs using my approximation of depreciation) and the other costs of ownership as discussed in the previous section. Also, whenever a replacement car was purchased, I assumed that the preceding car could be sold at the depreciated price.

New vs. Used

The two graphs below show the total cost over 60 years of owning each of the five cars. The three bars for each car correspond to buying a new car, a one-year old car and a three-year old car.  The first graph compares the total cost if you buy a replacement car every five years; the second, every 15 years.

If you replace your car every five years, it is clearly less expensive to buy a three-year-old car than a one-year-old car or a new one, though it becomes less important if you are buying inexpensive cars such as the Fusion.  The difference between buying a new car and a one-year-old car is quite large for the F150 and the BMW, both of which have high depreciation in the first year.

If you own each car for 15 years, the benefits of buying a used car are much smaller. In fact, the increased maintenance and repair costs of buying a one-year-old car essentially offset the high first-year depreciation for the Subaru, Toyota and Fusion.  Buying a three-year-old car is still clearly less expensive for all models.

More Expensive vs. Less Expensive

The Subaru and Fusion are fairly similar cars – both are basic 4-door sedans, though the Subaru has all-wheel drive.  If you don’t need all-wheel drive, you might be indifferent between the two cars.  By comparing the total costs of the Subaru and Fusion in the above charts, you can see that the long-term cost of ownership of the Fusion is less than that of the Subaru.  In particular, the cost of buying new Fusions is less expensive than buying three-year-old Subarus.

This comparison emphasizes the point I made in the Summary that the initial purchase price of your vehicle is a more important factor than whether you buy new vs used cars.

Length of Time Owned

The graph below compares the total cost of ownership if you buy new cars and own them for different lengths of time.

The longer you own your cars, the fewer times you need to replace them. Replacing cars fewer times is less expensive over the long run, even though you get less for them when you sell them.  One consideration when you own your cars for a long time is that you’ll need to save up more for the replacement car because you will get less when you sell the old car.

For the Subaru, Toyota and Fusion, there is a small difference in total cost between replacing your car every three years and replacing it every five years.  For the BMW and F150, which have higher depreciation, the benefit of keeping your car for five years is larger.

For all five cars, you will save a significant amount over your lifetime if you replace your cars every 15 years as compared to replacing them every three or five years.

The graph below emphasizes the importance of how long you own your car.  The blue bars represent the total cost of ownership if you buy new cars and own them for 15 years.  The orange bars correspond to buying a three-year old car and replacing it every five years.

For all fives makes and models, replacing a new car every 15 years is about the same total cost or slightly less expensive than replacing three-year old cars every five years.

Compounded Value of Savings

Many of my readers look at how much more money they will have when they retire if they make certain financial decisions.  I think this perspective is terrific, as it focuses on long-term financial objectives.  It also encourages financial responsibility in that these analyses assume that you will save the money in a tax-advantaged retirement account, such as an IRA or 401(k), rather than spend your savings on something else.  My post at this link provides more information about tax-advantaged retirement accounts.

Common Assumptions

I’ve read a few other posts that look at how much money will accumulate if you buy used cars instead of new cars and invest the difference in stocks.  These posts tend to make the following assumptions:

  • You have enough money to pay cash for a new car every certain number of years (such as 10), but buy a used one instead. One example I saw assumed that a three-year old car would cost 50% of a new car.
  • You replace your car when it is a certain number of years old, such as 10, regardless of whether you buy it new or used (three years old, for example).
  • You are able to invest the difference between (a) the stream of cash needed to buy the new car every 10 years and (b) the stream of cash needed to buy the used car every seven years in the stock market at 8% to 10%.

Better Assumptions

There are a few aspects of this process that most posts I’ve seen overlooked.

  • They exclude the cash you get when you sell your car.
  • They overstate the cost savings from buying a three-year old car. My analysis indicates that cars depreciate between 35% and 45% in that time frame, not 50%.
  • They ignore the other costs of ownership, especially the much lower repair costs and the maintenance costs covered by manufacturers’ warranties in the first few years of ownership.
  • They ignore the riskiness of investing in the stock market. That is, if you invest the savings from buying a used car in the first year, there is as much as a 15% to 20% chance that you will not have enough money in the seventh year to replace your used car.

In the discussions below, I will use essentially the same paradigm, but will refine some of the assumptions.  In particular, I will revise the investment assumptions so they:

  • better reflect the cash flow needs,
  • use the higher purchase costs for the used car,
  • include all costs of ownership, and
  • eliminate the risk that you might not have enough money to buy your second car.

This analysis is simpler than it could be.  In the entire analysis, I stated all of the cash flows in current or real dollars. That is, your actual savings will likely be higher than is estimated in this analysis because, with inflation, the cost of the more expensive strategy will be even more expensive than if we had assumed that all costs were subject to the same inflation rate.

Reasonable Investment Assumptions

To avoid the risk that you won’t have enough money to pay for the second used car, I will assume that you can earn 3% in an essentially risk-free investment for the first 10 years (until you replace your new car for the first time). In the current interest rate environment, you can earn close to 3% on CDs, corporate bonds or high-yield savings accounts.  After that, you have enough savings built up from buying two used cars instead of two new cars that you can afford to take on the risk of investing in the stock market.

I have used the annual returns on the S&P 500 from 1950 through 2018 to model the amounts you will have accumulated by selecting the less expensive strategies.

New vs Used Cars

For the first comparison, I will look at the example discussed above – buy a new car every 10 years or a used car every 7 years.  In this comparison, I calculated how much you would have at the end of 40 years if you invested the difference between the new car costs and the used car costs.  For the first 10 years, I assumed you would earn 3%.  For the remaining 30 years, I used the time series of 30 years of S&P 500 returns starting in each of 1950 through 1968 (for a total of 39 time series).  To reiterate, this comparison assumes that you invest the difference in a tax-advantaged account and don’t spend it on something else.

If you buy used F150s instead of new ones, the historical stock market returns indicate that you will have an average of $390,000 more in retirement savings at the end of 40 years with a range of $200,000 to $800,000.   For the Subaru, the average is $160,000 in a range of $75,000 to $350,000.

This analysis indicates that, if you prefer to drive fairly expensive cars that depreciate quickly when they are new, you can accumulate a substantial amount of money if you buy used cars for 40 years.  For less expensive cars that don’t depreciate as quickly, the additional savings amount isn’t as large but is still significant.

More Expensive vs. Less Expensive

You can get almost as much additional retirement savings if you buy a less expensive new car and own it for 10 years as you can if you buy the used F150 instead of a new one and more than if you buy a used Subaru instead of a new one. For example, if you buy the Fusion (currently about $15,300 new) instead of the Subaru Impreza (currently about $26,000 new according to Edmunds) every 10 years, you would have an average of about $300,000 more in retirement savings.  That additional money comes from:

  • the $11,000 of up front savings from the first car purchase,
  • the $8,000 of savings for purchase of the three replacement cars after trade-in,
  • the $250 to $350 a year less it costs to own the Fusion, and
  • the investment returns on those savings.

This analysis shows that you can save more by buying a less expensive new sedan (the Fusion) every 10 years than by buying a three-year old Subaru every seven years. That is, if instead of buying new Subarus you buy new Fusions, you will have an average of $300,000 in additional retirement savings, but only $160,000 if you buy used Subarus.

Length of Time Owned

You can also accumulate savings by buying cars less often.  For this comparison, I looked at comparison of buying new Subarus and F150s every five years and every 15 years.  If you replace the Subaru every 15 years, you will accumulate an average of $300,000 of additional retirement savings in 40 years as compared to replacing it every five years.  With the faster depreciation and higher cost of the F150, the average additional savings in 40 years is about $600,000.

Comparison of Options

The box and whisker plot below (discussed in more detail in my post on risk) compares the amount of additional retirement savings you will have under the options above.  Briefly, the boxes represent the range between the 25th and 75th percentiles, while the whiskers (lines sticking out of the boxes) represent the range between the 5th and 95th percentiles.  Recall that the only source of variation in these results is the different time periods used for stock returns – the 39 30-year periods starting in each of 1950 through 1988.

The first three boxes relate to the purchase of fairly modest sedans – the Subaru and Fusion.  The graph shows how much more retirement savings you will have if you either buy new Fusions instead of new Subarus (second box) or replace your new Subaru every 15 years instead of every 5 years (third box) than if you buy three-year-old Subarus instead of new ones (first box).

The last two boxes relate to the purchase of the more expensive F150.  Again, you will accumulate much more in your retirement savings if you replace your F150 every 15 years instead of every 5 years (last box) than if you buy three-year-old trucks instead of new ones (second to last box).

Final Words

Ultimately, you’ll need to buy a car that best fits in your budget and meets your needs. As you make your choice, though, you might want to remember that there are clearly ways you can save money even if you prefer to buy new cars.

My Next Car: Pay Cash, Borrow or Lease?

The finances of buying a car can be tricky.  In addition, there are so many other things to consider. What kind of car do I like?  How often do I want to replace my car?  How many people (and pets) do I need to be able to transport comfortably?  Through what weather conditions do I need to drive? Do I want a new or used car (as discussed here)? In this post, I’ll focus on the finances of purchasing a car once you’ve decided generally what car(s) fit your other needs.  Specifically, I’ll describe the financial considerations of three options for buying your next car: pay cash, borrow or lease. I will also provide a spreadsheet to allow you to compare the finances of specific deals.

The Basics of Leases and Loans

I have a post that provides all the basics you need to understand about loans.

There are plenty of resources available to provide you with information about leases, so I won’t repeat that information here.  Here are a few resources:

  • This article focuses on teenagers, but it covers a lot of important aspects of leasing. Consumer Reports is considered an independent source for information about purchases.
  • Edmunds is a company that values and researches cars, as well as having a platform for selling used cars. Its guide on leasing can be found here.
  • The first several sections of this post by Debt & Cupcakes (@debtandcupcakes) provide details about leasing, along with the pros and cons.
  • Real Car Tips also has a guide for leasing. Here is the link for the leasing guide.

Your credit score is an important driver of the terms you will be offered whether you lease or borrow.  When I looked for examples on line, all of the offers were contingent on your credit score being above 800.  A credit score of 800 is excellent.  I have a post on how you can check and improve your credit score.

The Finances of Owning a Car

Cars are expensive to own.  This post will focus on the cost of buying a car under three different options – cash, borrowing and leasing.  As you evaluate which of the options works for you, you’ll also want to make sure you are able to afford the other costs of ownership of a car.  In addition to the purchase costs discussed below, there are four other categories of expenses:

Fuel

Your car needs gas, diesel or electricity.  As you are selecting a car, you’ll want to consider the type of fuel your car needs, the miles per gallon the car gets and how many miles you are going to drive.

Registration

You will need to register your car every year.  In the states in which I’ve owned cars, registration is a function of the value of the car – the higher the value, the higher the registration fees. I recall that a car worth $20,000 cost about $300 to $400 a year to register, whereas the minimum charge (for older cars) was about $50 a year in Minnesota, but the amounts vary widely across states.  In other states, registration fees are a flat amount regardless of the age or value of your car.

Insurance

In all states you are required to buy car insurance. This post provides information on insurance you are required to purchase and coverages you might want to purchase.  Liability insurance usually doesn’t depend on the value of the car, though can be higher for sportier and faster cars.  The premiums for physical damage coverages (comprehensive and collision which protect you against damage to your car) increase with the value of your car.

Maintenance & Repairs

Cars need regular maintenance – oil changes, replacement brakes and tires, among other things.  Some dealers provide regular maintenance at their location for one or more years if you buy a new car, but that is not always the case.  In addition to regular maintenance, cars break down and need to be repaired.  Repair expenses tend to be higher on older cars.  Even on new cars, repairs can be expensive and unexpected.

You’ll want to keep some money in your designated savings for car repairs, as discussed in this post.  Another option is to buy an extended warranty to cover repairs to your car.  Extended warranties can be quite expensive, but cover the cost of some major repairs if they are needed.  I’ll write about extended warranties in another post in the future. If you choose to purchase an extended warranty, you’ll need to include that cost as part of your expenses related to owning the car, along with a provision for repairs not covered by the warranty.

How to Think About the Finances of Buying a Car

Determine Your Needs

I always find it helpful to define what I want and can afford before I go shopping for anything expensive, cars in particular.  My husband does all of the negotiating on price for our cars because that is a skill I never acquired and I don’t like the process so don’t want to acquire it.  I figure out what I need, what’s available in our price range that meets those needs and make a very detailed list so he can go to different dealers to negotiate the terms.

As part of your needs, you’ll want to think about the length of time you’d like to own your car.  Some people like to drive a new or at least a different car every few years.  I was that way when I was young – I bought a different car every 3 years for a bit.  I’ve always regretted selling the first one – a 1969 Mustang convertible. Live and learn!

Other people drive cars until they die or become unreliable.  Now that I understand the finances of cars better, I have moved to the second category.  The most recent two cars I’ve sold (both Honda Preludes) had 250,000 and 150,000 miles on them respectively.  The only reason I sold the second one is because I moved to a place with hills and snow, as opposed to flat and snow, and a Honda Prelude just wasn’t going to get me home reliably in the winter.

Figure Out What You Can Afford

The second step in the process – figuring out what’s in your price range – can involve several perspectives.

  1. How much cash do you have available to either pay for the entire car or put as an initial payment towards a loan or lease? As you consider that amount, you’ll want to take the total cash you have available and reduce it for the other costs of ownership I’ve listed above.
  2. If you aren’t going to pay cash for the car, how much you can afford to pay every month? Again, don’t forget that you’ll need to pay for registration, insurance, fuel, maintenance and repairs, too.
  3. If you can’t find new cars that fit in your budget, you might need to look at used cars. I have another post planned that will address the finances of buying new versus used.

Gap Insurance

Gap insurance is another expense you may have to pay if you don’t pay cash for your car. In some cases, you’ll want to buy it for your peace of mind.  In other cases, the lender or lessor may require it.

Gap insurance protects you against the difference between the value of the car and your outstanding balance at any point in time during the loan or lease.  Although it may not be clearly stated in your lease agreement, lessors think of your lease payments as including compensation to them for the reduction in the value of the car as you use it (depreciation) and interest on the value of the car (similar to loan interest).  As such, both loans and leases have outstanding balances at all times during their terms.

The chart below compares the outstanding balance on a loan with an estimate of the value of a $23,000 car over the term of an 84-month loan.  For this illustration, I’ve assumed that the borrower paid $1,000 towards the value of the car as a down payment and the loan has a 3% interest rate. I estimated the value of the car by looking at the clean trade-in value of a Ford Fusion from prior model years on the National Automobile Dealers Association (NADA) web site, a common source for lenders to get car values.

For the Ford Fusion, the loan balance is more than the value of the car between 4 and 36 months.  If the car is totaled, your car insurer will reimburse you for the value of the car minus your deductible.  During that time period, you will owe the lender not only your deductible but the difference between the blue line and the orange line.  To protect yourself from having to pay the additional amount, you can buy gap insurance.

You’ll want to investigate the cost and need for gap insurance for the particular make and model you are buying.  Cars depreciate at different rates.  For example, when I looked at the NADA web site for a Subaru Impreza, the value never went below this illustrative loan balance.

The Finances of Cash, Leases and Borrowing

Now that I’ve covered the preliminaries, we can get to the main topic of this post – the details of paying cash, borrowing and leasing.

Cash

When you pay cash for a car, there is only one number on which you need to focus. It is the out-the-door cost of buying the car.  This amount will include some or all of the following:

  • The cost of the car,
  • The additional cost of options you choose,
  • Sales tax (called excise tax in some jurisdications),
  • Processing and documentation fees,
  • Delivery charges, and
  • Title and registration fees.

Not all of these charges are included in every state or by every dealer.  I recently bought a new car in Montana. There is no sales tax in Montana, there wasn’t a delivery charge and you pay the state for title and registration fees directly, so the only things on my invoice were the cost of the car, the cost of the two options I added and a $100 documentation fee.  If you are comparing prices from different sources, you’ll want to make sure that they consistently treat all of these possible costs. For example, you should make sure they either all include or all exclude title and registration fees.   If not, you’ll need to add them to your analysis of the total amount you can pay for the car.

Leasing

The finances of leasing involve many important numbers, even more than borrowing.  All of these numbers should be available to you in the contract and from the dealer or leasing company. 

Up-front Payment

You’ll want to make sure you know the total amount of the up-front payment, including sales taxes, title and registration fees and the base charges from the dealer and finance company. The up-front payment often includes the first month’s lease payment, but not always, so you’ll want to be sure to know whether it is included for each offer you consider.

Monthly Payment

The amount that you’ll pay every month.

Sales Tax Rate

You pay sales tax on your monthly lease payments.You’ll need to know if the sales tax is included in the monthly payment you’ve been quoted and, if not, what sales tax rate applies.

Term

The term is the number of months you are committed to the lease. It is important to note that my spreadsheet assumes the lease term is 36 months and you will honor your commitment to the lease for its entire term.  There can be significant penalties if you choose to return the car before the lease ends.

Allowed Annual Mileage

Every lease contains a maximum number of “free” miles you can drive on average each year.

Estimated Actual Annual Mileage

You can use your actual annual mileage to estimate how much you will have to pay in excess mileage charges to understand the full cost of a least.

Cost Per Extra Mile

If you exceed the total allowed mileage (the allowed annual mileage times the term), you will pay an extra fee when you return the car. To calculate the extra amount, you first take your actual mileage and subtract the total allowed mileage.  You then multiply the excess miles by the cost per extra mile.  As I’ve looked on line at leases, I’ve seen several that charge 15 cents per extra mile.  If, for example, you drive 50,000 in three years on a car with 12,000 miles allowed and a 15 cent per mile charge, you will pay an extra $1,800 when the lease ends.

You may also need to pay a fee if your car experiences more than the normal amount of wear and tear. For example, if you live on a gravel road or a busy street, your car may have many more nicks and dings than someone who lives on a quiet paved cul-de-sac.

Residual Value

If you think you might want to buy the car at the end of the lease, you’ll need to know the residual value.This amount is what you will pay to keep the car.

Monthly Cost of Gap Insurance

If you want or need to buy gap insurance, you’ll want to know by how much it costs each month. You can buy gap insurance from your car insurer and, sometimes, the dealer, though I’ve read that buying it through the dealer tends to be more expensive.

Borrowing

The finances of taking out a loan for a car are a bit less complex than leasing. Here are the important numbers you need to know.

  • Up-front payment – You’ll want to make sure you know the total amount of the up-front payment, including sales taxes, title and registration fees and the base charges from the dealer and finance company. The up-front payment often includes the first month’s lease payment, but not always, so you’ll want to be sure to know whether it is included for each offer you consider.
  • Amount financed – This amount is equal to the total value of the car minus the portion of your up-front payment that goes towards paying for your car.
  • Monthly payment – The amount that you’ll pay every month. There is no sales tax on loan payments.  The sales tax was considered in the total amount of the car used to determine your up-front and monthly payments.
  • Interest rate – The interest rate, along with the amount financed and monthly payment, are used to determine the remaining principal on your loan at point in the future. If you want to sell your car before you have paid off your loan, you’ll want to be sure to know the amount financed and the interest rate so the spreadsheet can calculate the remaining principal.
  • Loan term – The term determines how many monthly payments you will make.
  • Monthly cost of gap insurance – If you need or want to buy gap insurance, you’ll want to know by how much it costs each month.

Illustrative Comparison

Because I just purchased a Subaru Impreza for around $23,000, I use it and two other cars advertised as having similar costs as illustrations.

The Offers

The table below summarizes the values I found on line and/or created for a Subaru Impreza, a Toyota Camry and a Ford Fusion

Although the cash prices are similar, the Lease and Borrow options have fairly different terms. The amount due at signing and monthly payment are much lower for the Toyota Camry lease than for the other two cars. The interest rates on the loans are very different, even though the monthly payments are all essentially identical. The Subaru has a lower interest rate and shorter term than the other two cars.  Because the payments are the same and the interest rate is higher, the amount due at signing must cover more of the cost of the Toyota than for the other two cars.

Not all of these values were clearly identified in the terms I found on-line.  The actual offers could be somewhat to significantly different from the values I’ve shown above.  Nonetheless, the differences in the terms help differentiate the total financial cost of these offers.

Look at Just the Subaru

We will first look at a comparison of the three options for the Subaru Impreza. Before we can do that, you need to determine for how long you want to own the car.  For illustration, I’ve looked at two options – own it for the term of the lease (assumed to be 36 months) or own it until it dies (or at least until you’ve made all of your loan payments).

Sell in Three Years

The first row of the table below shows the total of all of the payments you will make under each of the three options over the course of the first three years.  For the Cash option, it is your out-the-door cost. For the Borrow and Lease options, it is the sum of the amount due at signing, your monthly payments and the monthly cost of gap insurance.  For the Lease option, I added sales tax to the monthly lease payments.

Three Years Cash Borrow Lease
Upfront Cost + Monthly Payments $23,691 $14,133 $15,971
Amount on Sale 12,000 761 -1,350
Net Cost 11,691 13,372 17,321

The second row shows how much you would get or pay at the end of 36 months.  For all three cars, I have assumed you can sell them for $12,000 after three years. For the Cash option, the second row shows the total sales price of the car.  For the Borrow option, it is the difference between the $12,000 sales price and the loan balance.  For the Lease option, the value is negative meaning it is an amount you have to pay instead of receive.  It is the charge for the extra miles put on the car.  If you look at the inputs table, you’ll see that there is a 15 cent per mile charge for every mile over 12,000 a year and I have assumed you will drive 15,000 miles a year.

The third row shows the total net cost, calculated as the first row minus the second row.  For the offers for the Subaru Impreza, the Cash option is cheapest if you plan to sell after 3 years.  If you can’t afford to pay cash up front, the Borrow option is preferred to the Lease option.

Drive Forever

Under the Drive Forever option, the sales price of the car is assumed to be essentially zero, so we can look at just the cash outflows.  The table below summarizes the total cost of the three options.

Drive Forever Total Cost
Cash $23,691
Borrow 25,581
Lease 31,321

The total cost of the Cash option is the same as in the Three Years table.  There are no purchasing costs other than the amount paid at signing under this option.  For the Borrow option, the total cost has increased from the Three Years option because it now includes the monthly payments after three years until the loan is fully re-paid.  For the Lease option, the cost has increased by the residual value of the car, $14,000 in this case.  That is, in addition to the up-front and monthly lease payments, you’ll need to pay the $1,350 for the extra miles and $14,000 to buy the car from the lessor.

Using the longer time frame, the Lease option is even more expensive than the Borrow option.  Because the interest rate is fairly low, the additional interest paid after three years isn’t a lot so the difference between the Borrow and Cash options doesn’t increase by a large amount from what was observed for the Three Years option.

Look at All Three Cars – Three Years

The relative order of the three options varies depending on the terms of the offer. The graph below compares the net costs of ownership of the three cars if you anticipate selling the car in three year.

The values for the Subaru Impreza are the same as the ones in the third row of the Three Years option table above.  As can be seen, leasing isn’t always the worst option as was the case for the Subaru. The Lease option is less expensive than the Borrow option for the Camry and is only slightly more expensive than the Borrow option for the Ford, using the three-year time frame.

If you are indifferent among the three cars, you could also compare the costs among the cars.  For example, let’s say you don’t have enough cash to pay for the car up front, so you are looking at the Lease and Borrow options. The net cost of the Lease option for the Camry is about the same as the Borrow option for the Impreza.  The risk of the Lease option is that you will drive even more miles than you’ve estimated adding to the net cost of the Camry Lease option.  You would want to offset that risk with the risk that you might not get $12,000 for the Impreza when you sell along with the hassle of having to sell the Impreza.

This comparison highlights the importance of getting all of the detailed terms of every option.

Look at All Three Cars – Drive Forever

The graph below shows the same comparison for the “Drive Forever” option.

Other than the total costs of ownership being higher (because you are owning the car until it dies instead of having to replace it or selling it in three years), the relationships among the three options for each car are essentially the same. That is, the order and relative costs of the Cash, Borrow and Lease options are the same for each vehicle.

Of the Lease and Borrow options, the Impreza Borrow option is the least expensive in this example.  The Camry Borrow and Lease options and Ford Borrow option are all $3,000 to $4,000 higher, so you might choose from one of those if you didn’t like the Impreza.  If you have cash to buy the car outright, the Ford Cash option is the least expensive, though the Camry is only a few hundred dollars more.

In addition to comparing different makes and models, you can make similar comparisons among offers you obtain from different dealerships for the same car.

Can I Invest my Cash and Use it to Pay Off my Lease or Loan?

For those of you who read my post about Chris’s mortgage, you know that I suggested he consider paying the minimum payments on his mortgage and investing the rest of his money.  You may be wondering why I haven’t talked about the benefits of investing money under the Lease and Borrow options.

There are a few reasons.

  • Most people who buy a car using a lease or borrowing don’t have the cash available to pay for the car up front. If you don’t have cash to invest, there is no possibility of investment returns.
  • The term of a lease or loan is much shorter than the length of a fairly new mortgage. In Chris’s case, he had 26 years of payments left on his mortgage.  As I discussed in my post on investments and diversification, the likelihood you will earn the average return increases the longer you invest. With the short time span of a car loan or lease, investing in stocks with the expectation of having money to pay off your lease or loan would be very risky.  There is a fairly high probability your investments wouldn’t return enough to make those payments.
  • To avoid the chance that your investments wouldn’t cover your car payments, you could invest in something with very low risk, such as a money market account, certificates of deposit (of which you would need a lot to match the timing of your loan or lease payments) or high yield savings account. Low risk investments currently have very low returns – generally less than 2.5% pre-tax and even less than that after tax.  There are very few loans or leases that have interest rates (implicit in the case of a lease) that are less than 2.5%, so there isn’t much benefit in investing cash in risk-free assets until your loan or lease payments are due.

How To Use the Spreadsheet

To help you create your own comparisons similar to the ones above, I’ve provided you my spreadsheet at the link below.

Overview

The flowchart below will help guide you through the financial aspects of the car-buying process.  It assumes that you have identified one or more cars that will meet your needs and possibly fit in your budget.

The hexagonal boxes in a flow chart correspond to decision points. The rectangular boxes contain action items.

The first step is to determine whether you can afford to pay cash.  If not, you won’t have to negotiate a price for the Cash option for any of the cars you are considering.

Next, take a look at estimates of the up-front and down payments for the Lease and Borrow options.  If you can’t afford either of them in addition to the other costs of car ownership, you will need to find a less expensive option – either new or used – and go back to the top of the flowchart.

The next decision point is how long you want to own the car – the term of the lease (which I have assumed will be three years) or a much longer time (at least as long as the term of the loan in the Borrow option).  When you are done entering the values, you’ll look at the summary at the top of the Lease Term tab if you plan to own the car for the lease term and the Drive Forever tab if you want to own it longer.

If you want to own the car beyond the end of the lease, you’ll need to be able to afford to pay the residual value at the end of the lease.  If not, you’ll want to exclude the Lease option from consideration and focus on the Borrow option.

Collect Terms

Once you’ve narrowed down your choices to a few cars and figured out which of the Cash, Lease and Borrow options work for you, you will be ready to talk to dealers and other car sellers.  The Inputs tab of the spreadsheet lists all of the information you need for each type of purchase.  I defined each of the inputs earlier in this post.  For every deal you are offered, be sure to get all of these values.  I found that there are some of these values that are consistently unavailable if you look on line.  You may need to ask for some of these items specifically.  If you aren’t sure you are getting straight answers, you can always ask for the actual contract.  It is required to have all of the terms.

Enter Values in Spreadsheet

Next, enter all of the values into the Inputs tab.  Then, go to the tab that corresponds to the time period you plan to own your car – Lease Term or Drive Forever.  You can see the total cost of the options for which you entered the data.

If you have deals for more than one car, I suggest making one copy of the spreadsheet for each car.  You can then compare not only between the Cash, Lease and/or Borrow options for a single car, but can compare whichever options are available to you across cars.

Your final choice of car and deal could be the least expensive or a different one. It will all depend on your personal financial situation, your qualitative considerations and their relative importance.  Buying a car is an important decision, so cost may not be the only factor to influence your decision.

Download Car Comparison Spreadsheet