That New Car Smell

My company car is pretty squared away. I generally vacuum the interior and wash the outside by hand once a week. Every month or so, I will apply the mandatory coat of Armor All on the interior and the tires; twice a year, I wax the exterior. Yes, there is some pride put into it; but mostly, my sergeant expects it... and you know that if the sergeant ain't happy, no one is happy.

Despite all that effort, I am not a car guy. I haven't bought a new car in 11 years and have only bought two new cars in my whole life. This month, we'll look at automobiles and why they can be a financial pit.

Car Values

First, let's look at how a car is valued. The manufacturer prices a new car at an artificial price, called the MSRP (manufacturer's suggested retail price). The MSRP is just a dream number that some marketing guy wishes the car would actually sell for. The real price is normally several thousand dollars less than that, ultimately determined by the dealer. The dealer takes his cost and adds a few hundred dollars to determine his minimum price. Any purchase offer over that is just extra money in the dealer's pocket.

The price can be even lower with incentives and cash-back offers from the manufacturer; these normally happen at the end of the year or when inventory of a certain model is too high. The opposite can happen on popular, low-production models. For example, when the Dodge Challenger first came out, I saw one at our local mall that had a $15,000 availability premium tacked onto the MSRP!

There are three general categories for used car pricing: trade-in, private sale and retail sale. These values are set by a variety of publications, such as Kelly Blue Book, Edmunds or the National Automobile Dealers Association (NADA). The values are adjusted for age of the car, condition of the car, mileage and accessories on the car, etc.

The trade-in value is supposed to be what a dealership would offer you, considering they will have to clean and market the car, and maybe make some repairs to it. The private party value assumes that you just place an ad in the local paper and someone buys the car directly from you. The retail value is what a dealership could hope to get. Because the buying public has become so educated on car buying, and the resources to learn values are free online, the pricing has been a little more flexible. Private party sales are sometimes getting more, especially if the car is in good shape; dealerships are sometimes getting less for retail sales on used cars.

Leased cars are priced as new cars, but the payment schedule is different. In a lease, you are basically pre-paying for the use of the car. You do not own the car when the payments are over; you turn it back in to the dealer and lease a new one, or buy your old one for a fixed price. It is possible to negotiate the starting price, or capital cost (cap cost, or cap price), but most leases are designed around the monthly payment. The lease normally includes penalties for excessive mileage or wear on the vehicle.

New, Used or Lease?

Understanding how prices are set is one issue; looking at value is the next. Let’s take each one separately.

New: There are several advantages to the new car purchase. Probably the biggest is that, well, it's new! The smell, the look, the image... there is a psychological boost to buying a new car. There are no stains, no dirt, and no random marks. You also are not buying someone else's problems and you have a full warranty to cover any problems that crop up over the next few years.

There are negatives to a new car as well. One is cost; the Federal Trade Commission reports the average price of a new car is $28,400. Most people don't have 30 grand in pocket change, so new cars are usually financed. This is a double-whammy, as the new car loses its value fastest in the first few years. For example, that $28,000 new car might be worth $24,000 after just one year, and just $10,000 after five years. Over the next five years, the car may lose another $5,000 or $6,000 in value. Clearly, the value drops most quickly (called depreciation) in the first few years. If you finance a new car, you can quickly owe more than the car is worth (called being upside down or negative equity).

Used: A used car takes advantage of the depreciation problem. Most of the depreciation takes place in the first three to five years, so buying a car that old means you buy something that doesn't lose its value as fast. That normally means that you can buy more for less money compared to new. For example, a 2009 Ford Taurus Limited costs about $29,000 without any additional options. A 2005 BMW 530i, with all-leather, heated seats, satellite radio, navigation and more would cost less than $24,000.

The disadvantages to a used car can be problematic. You are buying someone else's dirt, scratches and stains... no matter how hard someone tries, there is still going to be evidence that someone owned this car before you. You could also end up buying someone else's problems. The warranty for the used car is probably expired, and we all know someone that has sold or traded a car because they were tired of repair bills. That can be a big problem.

Lease: There are not a lot of advantages to a lease. Unless you are a very specific driver, a lease is a bad deal. Remember, after the lease, you don't own anything; you just rented the car for a fixed period. But, if you are a car guy (or gal), and a new car every three years is just your thing, and you understand that you are paying extra to do your thing, then a lease makes sense. You get a new car every few years without the hassle of having to sell or trade in the old one.

On the flip side, you are paying for the depreciation on that car... and paying for it during the time when it depreciates the fastest. If you don't return the car with minimal mileage and in great condition, you'll be charged additional fees. After all those months of paying for the car, you have nothing to show for it. That's why Dave Ramsey calls it a fleece.

Conclusion

There's no doubt it feels good to buy and drive a new car. There is great comfort and pride in it, even though most people cannot pay cash for a new car, and end up financing a depreciating asset. New cars normally are financed over five or six years, which can lead you into a perpetual state of making car payments as you pay off yours then buy a new one for your spouse. A lease can keep the payments low, but you still have monthly payments and in the end, you have nothing to show for your money. Again, you get stuck into the rut of always having a car payment.

When it's all said and done, the used car is the best value. Yes, you can end up buying a lemon, which is why it is important to have a trusted mechanic look at the car first. However, you can buy more car at a better price by going used, and that makes it easier to pay cash for it and avoid going into debt for something that is guaranteed to lose value.

If you are one of those people that just has to buy new, and you are a car guy (or gal), that's your call... but drop me a line when you are ready to sell!

Be safe.