If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To learn the financial implications of purchasing or leasing a car, including how to compare a variety of options.
Prerequisites: PF104: Creating a Budget & Cash Flow Statement
Assignment: Auto Purchase or Lease Comparison in Excel | Google Docs (previews in lecture material)
Now that we’ve covered buying and selling a home, we are going to talk about cars. While cars are generally considerably smaller purchases for most families, they can have just as big an impact on your overall budget as a home purchase.
Here’s the things about cars—most people justify car payments because it is necessary for most families to have at least one car and often even two cars to be able to get to work, school events, sports and other social occasions. However, car debt payments are consumer debt and would definitely go under the “bad” debt category. This is primarily because they are not investments (yes, I realize there are specific cars that are the exemption to that statement…) but are actually depreciating assets. This means that they are worth less and less over time as they lose their usefulness. While a vehicle is a necessity for most, even if you need to finance it, a brand new luxury model simply isn’t a necessity no matter how you justify it. If you can afford a luxury car and pay for it in cash without ruining your other financial goals, go for it. If not, reconsider what your need for a car really is and minimize the cost so that you can reach your other financial goals.
Data from Experian showed the average car payment during the first quarter of this year is $503/month with an average loan term of 68 months. With the median income in the U.S. being around $56,500 that averages to nearly 11% of gross income going to the car payment alone not yet even factoring in the additional costs of insurance, gasoline, repairs and other vehicle costs. If you’re not reaching your financial goals, this is likely one of the first line items you should analyze in your budget.
Let’s take a look at some different options that you have when it comes to purchasing a new or used vehicle (or leasing) by taking a step-by-step approach.
STEPS TO BUY/LEASE A CAR
I like to take things step-by-step when it comes to all financial matters, but especially with regards to purchasing high-cost items like a home or car. Let’s get started!
STEP 1: DETERMINE YOUR NEEDS AND WANTS
The first step to take when you’ve decided to purchase a car is to determine your needs and wants and realize which really are needs and which are simply wants.
Your needs would include things such as:
- Number of seats to fit everyone in your family, including car seats for younger ones
- Cargo space if you take frequent family road trips or need it for occupational reasons
- Towing capacity if you have an RV or trailer that you pull behind your vehicle
- All wheel drive if you live on a dirt road or get heavy snowfall in your area
Wants would include such as things as:
- Specialized radio, DVD or other entertainment systems
- Newest model available (or a brand new car in general)
- Leather seats, sunroof, premium paint or other premium options
STEP 2: NARROW DOWN YOUR SEARCH TO SPECIFIC VEHICLE MODELS
After you’ve determined what you need and want in your vehicle, you should compile a list of vehicle makes and models that you’re interested in that include these features. Start researching the prices of models you’re interested in to see if there are some models that fit your needs that are significantly less expensive or that will hold their value better in the future.
At this step, you also should have a good idea of whether you’re considering only new or used purchases and if you have any interest in leasing a car (but you should analyze the cost differences in the next step, just to compare the real costs).
STEP 3: CALCULATE EXPECTED MONTHLY COST (OR CASH)
Based on your research, start filling out the information on the spreadsheet (it’s set up to be one model per spreadsheet with an analysis of new, used and lease costs). For a vehicle purchase, you’ll need to include the purchase price, your expected down payment, length of time for financing and the current auto loan interest rate (this will depend partially on your credit rating). This spreadsheet will calculate for you what your monthly loan payment will be under the various scenarios. Next, research lease costs for the same make and model that you are analyzing, preferably from the automobile manufacturer’s website.
For illustrative purposes, I chose to analyze the #1 top selling car in the United States, a Toyota Camry. I analyzed how much it would cost over a 5 year (60 month) period in time to buy or lease under 5 different scenarios: new cash purchase, new financed purchase, used cash purchase, used financed purchase and a leased vehicle.
The first half of this spreadsheet contains inputs to analyze the monthly payment based on the purchase price, down payment and financing terms.
If you look at the line item” Monthly Payment if Financed” (click on the picture below for a larger PDF version) you’ll see that it will cost $397.32/month for a the newest model, $278.30/month for a used model, and only $189.00/month to lease the vehicle. Leasing is popular because the monthly payment is significantly lower, but be sure to realize that the reason behind this is that after the lease term is up, you don’t own anything as compared to when you pay off your auto loan and still have a car that is (hopefully!) still worth something. In addition, you’ll always have a car payment if you lease.
After you’ve analyzed these initial costs, if you need to finance the vehicle, you should analyze the impact of the car purchase in your budget from our previous class PF104: Creating a Budget & Cash Flow Statement. Looking at the car payment in combination with the rest of your budget will help you gain clarity about how it will impact your finances and your other saving goals.
Bonus: If you want to analyze your automobile loan and how much more quickly you can pay it off with extra payments (you can do it!), go to this class: DM102: Debt Management. This class goes more into depth about loan amortization schedules.
STEP 4: CALCULATE EXPECTED TOTAL COST OVER A 1-5 YEAR PERIOD
We’ve already discussed the fact that vehicle payments are one of the most significant expenses for many Americans and can really break a budget. It’s vital if you are considering purchasing a car that you look at the total costs involved (not just the monthly payment!) and the impact it will have on your finances over the long-term.
At this step in the process, you may want to analyze total costs for 3 different options for the particular car model(s) you’re considering:
- Purchasing a brand new car
- Purchasing a used car (consider certified used!)
- Leasing a new car
Obviously, leasing a car is generally going to be the most expensive option overall and buying a used car with cash is the least expensive option. However, I wondered exactly how big of a difference it would make if I factored in increased maintenance and repairs for purchasing older cars and whether the near lack of necessary repairs and maintenance for leases would make them a better purchase (leases definitely get a bad rap and often for good reason!).
If you’re curious as to how much of a difference it makes in the total cost of owning your car, you’ll love this spreadsheet.
The bottom half of this spreadsheet analyzes what it will cost you to purchase a vehicle new via cash or financing, used via cash or financing and the cost to lease a new vehicle. You can select to analyze this over 1-5 years (in 1 year increments). To compare against leases, you’ll also need to choose a lease length (the most common are 24 or 36 months). To calculate the lease cost, the spreadsheet takes the average monthly lease cost and spreads it over the total term that you wish to analyze (such as 60 months).
In summary, this spreadsheet takes the total purchase price for the car, adjusts it to include financing costs and then subtracts the residual value of the car after the specified time period (for example 60 months). This amount is the total cost of the vehicle itself over that time period. Next, we include the other costs of operating the vehicle such as licensing fees, fuel, insurance, maintenance and repairs.
In this example shown, the total monthly costs are $452 for a new purchase with cash, $490 for a new financed purchase, $413 for a used purchase with cash and $444 for a used financed purchase. A lease would cost a total of $488 per month.
Note that these costs are variable for different people. You may have a much lower insurance cost if you are an older driver with a safe driving record. You may be able to complete certain maintenance and repair issues yourself, thereby saving a significant amount of money from what is shown. Feel free to adjust these costs as needed for your situation to be able to make a fair comparison of what it will truly cost you.
Some interesting points I found in this analysis include:
- In this particular situation, the end total cost to purchase new with cash and the cost to purchase used through financing are nearly the same (only about a $500 difference). Which goes to show you that saving and not going into debt really pays off! For the same overall amount of money, you could get a brand new car instead of a used car.
- In this particular situation, it’s actually LESS expensive to lease the vehicle than to finance it brand new at the current prevailing interest rate (4.00% for new cars) over a 5 year period. In addition, this time frame would cover two separate leases (the first being 36 months and then would cover 24 months into the second lease time frame—so 2 new brand new cars!). Of course leases have other restrictions (such as mileage limits).
- It’s a significant $4,650 difference between financing a new car to purchasing a used car with cash, even after repairs are factored in. Seriously, it’s definitely something to seriously consider. Plus, if you purchased a certified used vehicle, you are covered for a period of time (usually around a year) to make sure that the vehicle isn’t coming with any current issues that you’ll end up having to fix out of your own personal wallet.
Are you interested in how exactly to run your own analysis of total cost? Here’s how I calculated these numbers step by step:
Step 1. Make some decisions about the basic assumptions for the analysis. Decide on the time frame that you’ll be owning the vehicle to analyze (12, 24, 36, 48, 60 months). Also determine a lease period you would choose if you were to go that route (24, 36 or 48 months).
Step 2. Enter your state sales tax rate (as shown, the Michigan sales tax rate is 6% and was used in the previous example). If you’re not sure what your state tax rate is, just google it.
…and if you’ve not already entered the following in the previous step .. the expected down payment, expected length of time for financing and the current vehicle loan interest rates for new and used vehicles (use google to search or your bank’s website). An example search from Chase bank is shown below.
Step 3. Go to Edmund’s True Cost to Own© website and search for the new vehicle year, make and model you are interested in purchasing. Enter the new vehicle price and fees into the spreadsheet.
Step 4. Input the information from the 5 year cost to own into the spreadsheet under “new car annual costs”. Adjust any amounts you see necessary (for example, if you are capable of handling your own repairs and maintenance, drive significantly less than the average person, or see a big discrepancy in the insurance rate from what you will be paying.
Step 5. Go to Edmund’s True Cost to Own© website and search for the USED vehicle year, make and model you are interested in purchasing. Enter the used cash price into the spreadsheet.
Step 6. Input the information from the 5 year cost to own into the spreadsheet under “used car annual costs.” Make the same adjustments as you did in step 4, still accounting for increased repairs and maintenance costs due to purchasing an older vehicle.
Step 7. Research lease rates and terms for the new vehicle you are considering, preferably by going to the automobile manufacturer’s website. For the example shown above, I researched the rate directly from Toyota’s website.
Step 8. Analyze the total costs after all additional factors are considered (licensing, fuel, insurance, maintenance & repairs). The spreadsheet will show the total over the number of years selected (1-5) as well as a monthly break-down of costs.
Bonus step: Calculate the percentage of your average monthly cost of the vehicle is compared to your monthly gross salary. You can analyze it in-depth looking at this post about Budgeting Percentages, which recommends a total of 8-13% for total transportation expenses.
STEP 5: OBTAIN OUTSIDE FINANCING (IF CASH IS NOT AN OPTION)
If you need to finance your vehicle, you should secure financing before you start any negotiations at a dealership (and obviously this is a necessity if you’re purchasing from a private seller). Start with your personal bank or credit union, as they may have cheaper rates for those that have accounts with them. Do some additional research online to research other bank’s rates-shopping around could end up saving you hundreds of dollars. Apply for the loan and be sure to have the information with you when you are ready to start your purchase. We learned not to rely on last minute dealership financing from personal experience in our early days when my husband found the car of his dreams, drove several hours to look at it and financed it on the spot at the dealership at a 7.9% interest rate (ouch!). We even had reasonably good credit at the time.
On a similar note (learned from this same experience), make sure that your loan does NOT have a prepayment penalty. It’s very likely now that you’re getting your finances in order that if you do have to take out a car loan that you will pay off that loan early. Hopefully very early, so make sure you’re not going to be stuck with paying several hundred dollars extra just for making a good financial choice.
STEP 6: START YOUR SEARCH ONLINE
Your search should start on internet for your desired car models and makes since you’ll want to know the range (and costs) of options and other important factors. Autotrader.com is a great place to start, since they feature both new and used vehicles from dealerships as well as private sellers.
Looking at specific websites for dealerships in your local area is another great way to get the search started. They virtually all have tools to contact them through their websites and have a salesperson reach out to you through phone or email. This is a great way to start getting prices in a non-threatening or pushy way.
STEP 7: NEGOTIATE WITH THE SELLER (DEALERSHIP OR PRIVATE PARTY)
When you’re sure of exactly what you’re looking for (or have at least narrowed it down a little!), you’re ready to get serious about the purchase. Test driving the car will be the first step you take before negotiating, which is especially important if you’re considering a used car.
Be sure to negotiate with the seller/dealership and keep the focus on the sticker price of the car NOT the monthly payment. They will always go back to showing you how they’ve lowered the monthly payment or try to convince you to lease because the monthly payment will be lower. Don’t let them upsell you on a “nicer” model if the features aren’t necessary for you and if it’s not in your budget. Keep your focus on the purchase price and do your best to negotiate down on the car you really want.
STEP 8: FINALIZE THE SALE
Once you’ve secured the paperwork including the loan documentation if you’ve financed the vehicle, you’re ready to roll away in your new (or new to you!) car. If you’ve done all of this work to make sure it’s the car for you—and the car for your budget—enjoy the ride!
EXAMPLE: THE SMITH FAMILY
The Smith family has a financial goal to purchase a new vehicle for Jim within the next 2-3 years, since his car is getting old and they are concerned that it may start to need more repairs than it is worth. They’d love to get a brand new car, but with their current debt situation, they want to compare the cost of buying a used car. For good measure, they’re going to compare current lease prices as well. Because they already have a separate larger family car, Jim is looking at a mid-size sedan such as a Chevrolet Malibu that will still be comfortable, but also get good gas mileage.
He gathers the information shown below about the 2016 model and also finds that there is a special 2.9% financing deal on this model through the manufacturer.
And for a lease, he finds the following information from the manufacturer’s website, which includes a $350 “disposal” fee in the fine print. This is also a low-mileage lease, so it definitely wouldn’t be a good option for him, but he’s willing to quickly compare the total cost for information purposes.
For the used 2013 Malibu model, he finds the following information from the True Cost to Own© website.
Based on all of this information, he finds that assuming he will not be able to pay cash for the vehicle and would likely need to finance the majority of it, buying used will save him over $3,500 over a 5 year period (calculated as the difference between the $516.02 total average monthly cost for new and $457.62 total average monthly cost for used times 60 months total).
Your homework assignment is to analyze an upcoming or future potential vehicle purchase using the tools provided in this class.
- IMPROVING – Look at Edmund’s true cost to own (5-year) of a car model you are interested in. Compare a couple different models & years. Seriously consider a used car purchase and whether you can set a goal to purchase your next car with cash.
- INVESTED – Use the spreadsheet to analyze the different new/used, cash/financed, lease options for a specific make and model you are considering. This will give you a good overall idea of the costs involved. Include in your financial goals a monthly saving amount to provide cash to pay for your next vehicle or pay off your current auto loan (debt free is always an important financial goal!).
- UNSTOPPABLE – Well in advance of the potential purchase, update your budget to see the impact of the monthly auto payment, or even better start saving the cash now as one of your financial goals. Use the spreadsheet to analyze several different scenarios (as explained in “invested”). Complete different versions of the spreadsheets for several different car models.
File your car purchase analysis in your Financial Plan binder under the tab “Special Situations”.