I was recently faced with the ultimate financial decision: Buying a new car. The intrigue and feeling of buying a brand-new vehicle is very exciting. However, the excitement starts to wear off after the fresh car smell is gone and you have made four to five auto payments.
Some people ask, “Did I just make a financial mistake?”
With 121,000 miles on a car valued at $2,000 yet needing $3,000 worth of repairs, our decision was clear: we needed a new vehicle. But we needed to figure out where to start. We contacted a trusted financial advisor about potentially getting a brand-new car. His advice was an emphatic two-letter word: no.
He repeated, “No, never buy brand-new cars.”
Why Should I Choose a Used Car?
After housing expenses, transportation expenses are second in monthly budgets. From auto payments to insurance, gas to maintenance, cars will average the average American over $12,000 a year.
While some aspects of transportation expenses are less controllable, the one controllable automobile expense is your monthly car payment.
Ultimately, the buyer (you) decides to take on monthly car payments and what size those payments are. So if the average adult is spending nearly as much on their car every year as they are on their home, here is a financial nugget: cars are a financial liability, not an investment.
On average, a brand-new car costs around $750 per month. Yet, that same new car will depreciate so fast that in five years, when it is finally paid off, it will only be worth 37% of the initial purchase price.
The solution is simple: buy used, and here are seven reasons why.
Cars Depreciate at a Rate of 20% A Year
A brand-new car depreciates at a rate of 20% per year on average. In fact, the second you drive it off the lot, it has already depreciated 11%.
That's like saying you bought a laptop at BestBuy for $1,000, and when you decided to return it the next day, they say it is only worth $890.
Imagine if all things depreciated as fast as a car – Your $300,000 home is worth $277,000 the day after you moved in. At the end of the first year of homeownership, your home is worth $240,000.
Most would be freaking out if they knew their house lost 20% of its value in one year. But for car ownership, it's something we accept without second thought.
Car Payment Can Hurt Your Debt-To-Income Ratio
Your debt-to-income ratio refers to the money you pay monthly towards debt in monthly payments, compared to your gross income. To figure out your debt-to-income ratio, add all monthly debt payments (auto, student loans, credit card, mortgage, personal loans) and divide that number by your gross income.
For example, If you gross $4,000 monthly and have $2,000 in payments, your debt-to-income ratio would be 50%.
Buying a car can significantly impact your debt-to-income ratio, and this is important if you're trying to buy a house because if your debt-to-income ratio is higher than 43%, you will have a tough time getting a qualified mortgage.
Or, as mortgage loan consultant Brian Scott put it, “buying a new car can potentially keep you from qualifying.”
Cash Is King
A new car can significantly hinder your debt-to-income ratio. And if you have never heard of your debt-to-income ratio, chances are you will. The average person with a car payment will spend almost $750 per month or roughly $9,000 annually on their car payment. $9,000 is a large amount of money that could be going to something that pays you instead of something that depreciates.
You can save more, pay off debt (like student loans), or invest in retirement by not having a huge monthly auto expense.
The monthly car payment sabotages your cash flow. More freed-up cash in your monthly budget gives you options and financial security is all about choices. Our household vehicle costs are a combined $320 a month – fuel & insurance – which is only about 4% of our monthly budget.
Cash flow is more important than driving a brand-new vehicle. There are better options than buying a new car, like refinancing a car or downsizing. Always explore those first.
A New Car Is Not an Investment
Contrary to what many think and are told from a young age, a car is not an investment. Sure, a paid-off car does count in the asset column, according to the IRS, but other than that, cars are not true assets.
Read any book about finances; people with solid financial portfolios do not view their cars as assets– they view them as liabilities. The experts consider cars as a necessary expense to get from point A to point B.
Why is a car a liability?
For starters, the depreciation factor. An asset produces and grows (think investments); it does not depreciate. A liability decreases in value, such as a car. And in addition to depreciation expenses, vehicle owners should also expect to budget $150 monthly for yearly car maintenance and tires.
Car Companies Want You To Have Payments
A simple trick to all personal finance situations: think the opposite of what you're being told.
The laptop warranty you “really need to have” is a warranty you probably don't need. Using the same logic, car companies use car payments to help buyers think they can “Afford new cars.”
By getting you to focus on monthly payments stretched out to 60 and 72-month loan terms, they can get you to a point where you can afford that new car.
But do the math – making a car payment for 5-6 years is a long time. And remember, by year five, your car is worth 60% less than the purchase price. The only one benefiting from your new car purchase is the dealership. And maybe the loan providers.
Used Cars Are Simply More Affordable (By About 40%+)
When you buy a certified pre-owned car, you're not only walking away with an almost brand-new car but saving close to 50%.
Most lease terms for cars last 24-36 months, which means a few things:
- Leased vehicles have low miles
- Routine maintenance is almost always performed
- They are generally low mileage but like new
So when you go to buy a used car, you're getting a steal, and you let the previous owner or lease eat the 40% depreciation if you buy two years used.
Personal Note: When we decided to buy a used 2016 Altima, the original purchase price was $27,000. We spend less than half, even with taxes and tags.
You'll Overspend With Your New Car Purchase
The biggest issue with buying brand-new cars is that most people don't understand what a reasonable price is for a brand-new vehicle.
Car companies will use sales tactics like leasing cars and long loan terms to get customers to buy new cars – even if they can't really afford it. While buying a house means you use a budget and get preapproved, in most cases, buying a car isn't so stringent.
In order to prevent overspending on a car, new or used, always follow the 25% gross income rule when it comes to car buying.
When buying a car, to make sure it is within your budget, be sure to follow these steps:
- Take your gross income and divide by four to figure out 25% of your gross income
- Buy a car that's value is no more than 25% of your gross income
For example, if you make $50,000 per year, your car's value should be no more than $12,500.
In most cases, this means you're looking in the used car lot.
When Should You Buy a Used Car?
Most financial experts recommend buying used vehicles around the two-year mark.
By buying pre-owned, you wind up saving 40%; you can still get a nice car and cut your payments in half. If you catch a Labor Day deal, you get to save even more – see Edmunds, KBB, or CarGurus.
A simple way to guide you in buying your car is this: your car should never cost more than half of your net annual income. For example, if you take home $40,000 a year, a vehicle that costs $20,000 is way too expensive.
Other items to consider when buying a car are the costs associated with:
- Maintenance costs
- Annual fuel expenses
- Insurance costs
- Personal property taxes
Sometimes, a car payment is, in fact, manageable. However, when coupled with all the other associated expenses, it can become unmanageable and impact your savings rate.
Just Don't Buy a Car Brand New
Whenever I see this on Facebook, I want to scream, “Just purchased my dream car; hard work really does pay off!”
The only thing worse than the statement is the 136 likes and 23 comments, saying things like, “Awesome job” and “Keep up the hard work!”
Keeping up the hard work was what I had to do to afford my brand-new truck, which I should have never bought. I constantly did odd jobs and counted pennies so that I wouldn't feel stressed about my $400+ truck payment.
Not to mention, going from no monthly auto payments to now paying for a truck, taxes, more fuel, and more insurance cost me close to $800 a month!
I quickly came to my senses, and nine months into my truck ownership, I quickly got rid of it and settled for a used sedan. David Bach, a self-made millionaire and financial author, said, “Buying a brand new car is the single worst financial mistake you can make.”
So the best piece of advice I can give you when it comes to buying cars is to buy used. Do things differently now so you can live like no one else later!