After buying a home, one of the next major purchase decisions (and expenses) is a car. The latest headlines, including a recent article in The Wall Street Journal titled “Buying a Car Now Is Brutal,” talk about how the market for cars has been turned upside down due to lack of inventory and parts availability and the transaction price of used cars is up 24% from June 2020.
With minimal deals to be had, buying a car now appears to be more challenging than it was in the past.
Whether to lease or buy can depend on your circumstances and preferences. I made a rough calculation a few years ago while having a discussion with a co-worker (assuming the car market is behaving normally) and the conclusion was whether you bought or leased the exact same car, you would likely break even at about the three-year mark. Before that point, you may spend less on a lease, but after that, you’d tend to come out ahead by buying. Why? Because the lease payments take into account the big depreciation hit you experience with any new car, which is highest in the first two to three years. If you lease, you are still paying for the depreciation.
For example, if you buy a $50K car for cash, after three years you will be able to sell it for say $30K, which means you “spent” $20K owning the car for those three years. If you lease the car, your three years’ worth of lease payments will likely be very close to the same $20K, due to the depreciation factor. If you buy and keep the car longer than that, it continues to depreciate — but at a declining rate over time. So, owning the same car for six years is then cheaper than leasing for six years. The break-even point is around three years.
So one way to save is to buy a two- to three-year-old car that has already taken the initial depreciation hit, keep it for seven to 10 years, and hope the repairs are not expensive.
Things to Consider When Buying a Car
Do You Want to Pay Cash or Finance?
Depending on interest rates, it may make sense to pay cash if you have sufficient cash available. If you have $50K sitting in cash earning 1% but your loan would be at 6%, it may make financial sense to pay cash. If the $50K is all you have in emergency savings, you may not want to tie up funds in a depreciating asset and prefer to go the finance route, especially if you are still working. Another consideration would be the probability of you replacing that $50K with new savings once it has been used to buy the car. Some people psychologically have a harder time paying themselves back tha n paying the bank. Interest rates for new cars are usually lower than for used cars and often the dealer may offer very low-interest financing.
If your $50K is invested in the equity market and you expect a 7% return or more over time (although the market can go either way), you may prefer to finance and leave your money to grow.
Another important aspect for retired clients is if your money is all in an IRA or other retirement account — taking out a $50K lump sum to buy a car may actually be a $70K withdrawal once you factor in taxes and may push you into a higher tax bracket for that year.
Maintenance and Depreciation Costs
If you are buying a car, you would want to check into what is covered under warranty and for how long. Anything not covered would be your responsibility and an extra expense. Some warranties on new cars are not worth the paper they are printed on (expensive mechanical systems that tend to give trouble are sometimes not covered) and often the dealer will try and talk you into purchasing an extended warranty.
Should you buy an extended warranty? Well, it’s a gamble that works similar to insurance, but you would want to understand the types of repairs you are insuring against to make sure the coverage is worth it (they don’t cover everything). Some warranties are expensive, and it may make sense to just save the cash you would pay for the warranty in case the car needs repairs. If you cannot afford to repair the car if you had a costly problem, then it may make sense.
Another point to consider is if you have an accident with a car you own, when you try to resell it you are going to get a lower value for it. Some insurance policies offer coverage for this possibility. Before choosing a car, check out resale values for that type of car so when you are ready to sell, you will have an idea on the future valuation.
In order to get a sense of how much a car costs, TrueCar.com or Edmunds.com are great tools. TrueCar aggregates all the new or used cars in the area based upon factors you determine (make, year, model, etc.).
Most car dealers have some negotiating room, which can be up to a couple thousand dollars, especially if a new model is coming out, so do your research before negotiating.
Things to Consider When Leasing a Car
If you tend to keep cars for a long time, purchasing may be the way to go, but if a shiny new toy every few years is your thing, you might want to look into leasing. If you believe your circumstances may change, such as a new baby on the way, elderly parents coming to live with you or a future move from a summer climate to a winter climate, leasing provides more flexibility since you are not committed to the car for more than two to four years. Also, you will likely be able to get more car for your money with a lease.
There is usually an upfront cost to leasing, which is an amount due at signing (tax, tag, title, down payment, delivery costs, etc.). This lump sum usually reduces your monthly payments and may be required depending on your credit. Some dealers offer $0 down, but all this does is increase your monthly payments; it is all a numbers game — a higher down payment means lower monthly payment and vice versa. To get an idea on what you are really paying each month on average, you may want to divide the down payment by the months of the lease.
Maintenance & Mileage
Some brands have scheduled maintenance included, which can be quite convenient. However, there are also several coverages, such as tire protection and dent and scratch insurance, that you can buy that will increase your lease payment. Most standard lease offers allow 10,000-mile limits per year. If you drive more than 10,000 miles, this will also increase your payments on the front end, or on the back end when you return the car you will be required to pay for the extra miles.
It is usually cheaper to pay for the miles before you return the car, and in some cases there is a time frame (you have to buy the extra miles three months before the end of the lease). Extra mileage can range from around $0.15 to $0.30 per mile and can add up fairly quickly. At $0.30 a mile 3,000 extra miles will cost you $900.
So, if you drive more than 15,000 miles annually, purchasing a car maybe cheaper for you — and if you are driving 25,000 miles a year this can get restrictive and expensive. Keep in mind even on a purchased car, the increased mileage will fetch you a lower sales price when you are ready to sell anyway.
Leases also require full insurance coverage to protect you and the leasing company, so if you want to pay for less insurance, purchasing may be a better alternative. Additionally, leased cars usually have GAP insurance built in; this pays the difference between what you owe and what your car is worth if stolen or totaled in an accident. Loans do not usually have this coverage, so you would need to check with your insurance company to see if this is something they offer.
There are some companies/websites that will allow you to lease a car on a month-to-month basis, which may be beneficial depending on your circumstances. If you have to terminate your lease early, www.swapalease.com is a useful website that I have used several times in the past and found very efficient; however, not all car brands are supported.
Lastly, if you own your own business and can use lease payments or mileage allowance as a tax write-off, this may be another factor to consider.
Senior Financial Adviser, Evensky & Katz/Foldes Financial Wealth Management
Roxanne Alexander is a senior financial adviser with Evensky & Katz/Foldes Financial handling client analysis on investments, insurance, annuities, college planning and developing investment policies. Prior to this, she was a senior vice president at Evensky & Katz working with both individual and institutional clients. She has a bachelor’s in accounting and business management from the University of the West Indies, she received an MBA at the University of Miami in finance and investments.