FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 2.2: Vehicles
This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.
If you were a software engineer and your first company had just gone public, I wouldn’t say a thing if you wanted to celebrate by buying a Ferrari. You, however, are a helping professional and you don’t need a Ferrari, and, more importantly, you can’t afford one. Expensive cars are an indulgence, not a necessity. Furthermore, expensive cars are a frivolous indulgence—they depreciate to nothing over time. All that I will grant you as a necessity is dependable transportations that gets you safely and comfortably where you need to go. People are pretty silly when it comes to cars, so many of us have just taken it for granted that a car note needs to be nearly what our mortgage is. This is not the path to becoming wealthy! As Dave Ramsey put it, “Taking on a car payment is one of the dumbest things people do to destroy their chances of building wealth.”
It is hard to imagine a worse investment than a car (unless you are thinking about a mobile home). They are over engineered, overpriced and full of gadgets that you seldom ever use. They depreciate at a remarkable speed! Casinos and penny stocks are the only other ways I know of to lose money that fast. A new car loses about 20% of its value when you drive it off the lot and it is no longer “new.” Bought a shiny new $50,000 car? You just flushed $10,000 down the toilet; and, to add insult to injury, you have to pay interest for sixty months on the flushed cash! The secret to becoming wealthy is to invest your money into appreciating assets, and a vehicle is a depreciating one.
To put it mathematically: CAR = POVERTY.
The average American household has over $29,500 in debt to own automobiles.
Taken nationally, Americans hold a staggering $1.1 Trillion in auto loans.
Am I saying you shouldn’t buy a car? If you live in a big, urban area with reliable public transportation, then that is exactly what I’m saying. If you, like me, live in a rural area with no public transportation, then you don’t have that carefree option. You need a vehicle. In that case, I just want you to remember that it is a depreciating liability, and to treat it accordingly. And the pain doesn’t end there; because its value is higher, you’ll also have to pay much more in sales tax. The check that you write to your insurance company will be bigger as well. If you are young, male, and single, insurance companies hate you already. Don’t give them more ammunition against you by buying an expensive vehicle. Don’t focus on merely looking wealthy so that your broke friends are impressed by what you drive. Take solace in having more money than they have.
The financial experts converge on one opinion when it comes to automobiles: Leasing is for suckers. Think of leasing a car as a lengthy rental period or as a “rent to own” program with horrible conditions for the consumer. This means that what little equity there is in a vehicle is owned by the company leasing you the vehicle and not you. As I argued against renting a home, you don’t want to lease for the same reasons. When the lease expires, you have a couple of options. The first is to return the vehicle to the company you leased it from. They will then fine you for every little scratch and stain they can find. They will also charge you a staggering amount of money for every mile you put on the vehicle beyond the ridiculously low number that was in the fine print you didn’t read on the lease agreement. The other major option is to purchase the vehicle for a price stated in the lease agreement, which is almost always well beyond what you could have negotiated on the same make and model with a used car dealer.
Dealing With Dealers
When you walk into a showroom, you will be greeted by one of the friendliest people you ever want to meet. Car dealers use the same tricks detectives use to get killers to confess–they know how to build rapport with the suspect. Once you get that warm fuzzy feeling that you are dealing with true friends, they’ll probably let you in in a great value they’ve been thinking about themselves. Don’t fall for any of this salesmanship. You’ll want to have a few of your own Jedi mind tricks.
Your first trick is to do your homework. You need to know the make and model you want as well as the Blue Book price (look this information up on KBB.com). When approached by a salesperson, let them know that you plan to pay cash. In this context, “paying cash” doesn’t mean that you have a brown paper bag full of small, unmarked bills. It means that you are not interested in dealer or manufacturer financing and that you have already made financial arrangements. Even if you insist on financing a vehicle against financial advice, you’ll almost always get a better deal from credit unions and banks than you will from the financing the dealer sets up for you. Have a firm upper limit for your purchase in mind before you walk into the dealership. Car salespeople are very good at convincing people to buy more car than they can really afford (the ones that can’t don’t last long in the business). Know your limit and stick to it no matter what.
Car salespersons are people, and people like to make money. In the car business, those who sell the most cars make the most money. This is because dealerships pay bonuses by the month, by the quarter, and by the year. To find out when incentives for sales staff are highest, check with TrueCar.com. (Edmunds.com is another valuable resource for finding the true market value of cars). This digital service (on the web or with the app) monitors millions of sales from thousands of car dealerships all over the country. TrueCar tracks sales incentives by the day, week, and month, and provides users with the average discount for each.
It also tracks the best times to buy certain types of vehicles (e.g., SUVs, pickups, and sedans). You will also not seasonal discounts, such as in the dead of winter when potential customers don’t get out much. Interestingly, one of the worst times to buy a car (and get a good deal) is when the dealerships are touting amazing sales and offers. These tend to be seasonal gimmicks, such as Fourth of July sales and Christmas events.
Because most people shop for cars on weekends, the best time to shop for a good deal is when the dealership has tumbleweeds drifting across the parking lot. The slowest time for dealerships–when they are willing to make the best deals–is on Monday. Discounts tend to go up in the month of May, most likely due to aging inventory concerns by the dealership. October (toward the end of the month) is another good time for deals. If you see that Halloween falls on a Monday, then that will be an auspicious time to buy that truck you have been considering. December is another logical month in which to look for discounts because manufacturer and dealer sales incentives converge for the quarter and the year.
Many people will tell you that you absolutely must haggle to get the best deal on a vehicle. This may be true if you have it in mind that you can’t leave the dealerships without a purchase. Another tactic is to make an offer that you will not budge on based on your homework. It needs to be a reasonable offer based on the going rate for the make and model you want. Dealerships have to make at least some profit before it makes sense to sell. You can simply make your offer, and answer any counter offer with a statement like, “Thank you, but my offer is firm. I am definitely a cash buyer if you accept my offer before someone else does. Let me give you my number in case you change your mind.” Give them the number, and then leave.
Do the same thing at several dealerships. The odds are that one will call you back and accept the offer if it is reasonable. True negotiation requires give and take; I advise against that. Make an offer and stick to it. If the strategy doesn’t work, then you’ll need to go back to your homework and see if you’ve incorrectly derived your fair price offer. If you catch a salesperson needing a sale to make a quota, you can likely get the price down around $500 to $1000 under market value. The key is to use hard data, not emotional spending and high-pressure sales tactics.
That New Car Smell
As I want you to become a Prodigious Accumulator of Wealth (PAW), It is my sacred duty to convince you that that new car smell is actually the stench of poverty lurking around your monthly budget. You may recall that automobiles are a depreciating asset class and, from a financial perspective, should be avoided altogether. Unless you live in a major metropolitan area, you most likely need a vehicle. You never need a new vehicle. It is important to understand that vehicles depreciate over time (except for the rare few exotic cars that become collectibles). The pain of vehicle depreciation is most acute in the first year when a vehicle can lose as much as 20% of its value. It is actually amazing how much the value goes down when you drive a new car off the lot. Once you take possession of a new car, it is no longer new and the premium “value” of newness has worn off. The bottom line is that If you insist on driving new cars with payments your whole life, you will blow what could be (given the magic of compounding) a fortune on them.
If you really want a new car, consider buying a “Certified pre-owned” vehicle. Certified pre-owned is another term for “used.” Most of the time when you buy a used car, it is sold “as is.” Meaning if the motor falls out as you are pulling off the lot, you are on the hook for the repairs. Certified pre-owned programs usually mean that the company selling the car has inspected it and found it to be mechanically sound. There is usually a warranty included that works much like (or exactly like) the original warranty the original buyer got. The exact nature of these programs will vary from company to company, so be sure to read the fine print before you commit to anything.
Be aware of the fact that car dealers make as much or more money upselling you on expensive products like extended warranties than they make selling you a vehicle. Since the dealership makes such a big kickback on these things, you will almost never get a good deal buying them from a dealer. They are especially bad deals if you finance them and are charged lots of interest on what is a bad price to begin with. The biggest kickback usually comes from the finance companies that you dealership “helps” you find. This is another reason that you are much better off paying cash for a vehicle. Note that most millionaires are not willing to accept the financial pain that new cars deal out. Millionaires often pride themselves on driving a used car in great shape that they got for a bargain price.
If You Must Finance
Despite my repeated arguments against it, you will most likely finance a vehicle at some point. I’d much rather see you pay cash and get a great deal that cash often motivates sellers to make. Much of the time, you will get a better deal on financing working directly with a financial institution rather than you will with your dealer. There are rare times that dealer arranged financing is better, such as when a particular make and model are overstocked and the model year has or is about to expire.
To evaluate these situations, you need to pay close attention to the price that you will pay as well as the interest rate of the loan. Very low-interest rate financing is often just a ruse, and you will more than make up for those savings by paying way too much for the vehicle. Dealers also make a large portion of their profit by upselling you on various things that you don’t need, and they have a sneaky way of sneaking those items into your finance agreement. When you are spending your own money (or money you are borrowing from a lender outside of the dealership), you can focus on the underlying cost of the vehicle rather than making the huge mistake of worrying about the monthly payment figure.
Be sure you take the time to calculate the entire budget for your new car before you make a purchasing decision. You need to adjust your budget to reflect the new loan payment along with insurance, fuel, and maintenance expenses. The more expensive the car, the more expensive insurance and maintenance are likely to be.
Long-term auto loans will make you bleed money. If you can’t handle the note on a 36-month loan, you are probably buying too much car. Under no circumstances should you ever borrow for a term exceeding five years. The reason for this is that the longer you spread out the time to repay the debt, the more you are spending in interest. Remember, interest on the debt is compounded. It is the reverse of wealth accumulation. You wouldn’t stay in a mutual fund with a terrible performance for 6 years, so why would you stay in an expensive loan for any protracted period of time? If you decide to finance, you need to consider what the purchase will do to your budget. If you don’t already have a note, then the monthly expense must come out of your monthly savings (otherwise known as “disposable income”).
Don’t fall for the old myth that you are getting a great deal if you sign up for zero percent financing. First of all, most people don’t have the astronomical credit scores to qualify, so the dealer will use your “embarrassingly low” credit scores as justification for making you another, less lucrative, offer. Note that your new car will lose more than 60% of its value over the life of your loan. A 60% rate of depreciation is not “zero percent.”
References and Further Reading
The author of The Millionaire Next Door has much to say about vehicles. You are strongly encouraged to read that text carefully before you go car shopping.
If you are interested in an in-depth discussion of why leasing is really fleecing, see Dave Ramsey’s The Total Money Makeover.