Deciding what type of vehicle to drive, how much to spend, and ultimately, how to finance our vehicle purchases is one of the most stressful and important financial decisions many of us are faced with in today’s society.
For many of us, our car not only serves the practical needs of getting to our daily destinations, but also represents an extension of our personality and is a way we wish others to perceive us or our values.
As an example, perhaps, you are environmentally conservative as well as economical and choose to drive a Toyota Prius for the gas mileage. Alternatively, you may have a large family and need a full-sized SUV in order to haul children to school or other activities. Our vehicles are a representation of our current stage of life and our mobility needs.
Regardless of the type of vehicle you choose to drive, unless you’ve hit the lottery, buying a car and operating that car will cost tens of thousands of dollars over the course of your life which can greatly hinder your financial well-being. While you probably do appreciate the functionality, and if you drive a nicer vehicle, the luxury, you probably do not realize the opportunity cost of your vehicle.
Because everyone has a limited source of funds, we all have alternative uses of each dollar we spend on a daily basis. What if, instead of purchasing that expensive car, you opted for an older year model or a pre-owned vehicle and invested the difference? While you may see this as a “sacrifice,” your future self will reap drastic financial rewards.
Just as a brief example: The average new car payment in the U.S. is around $530/month. Should you instead invest this amount in the stock market at the historic return of 10%, after 45 years, you’d have nearly $5.6 million in investments.
As part of this discussion, we will examine the opportunity cost similar to the above example in buying a new car, a used car, and taking out a lease to drive. We’ll discuss the overall opportunity cost of purchasing each as well as the pros and cons of making the decision to drive a brand new or used vehicle. In the end, we’ll compare the total net cost of ownership over a 20-year period which will help you decide which general vehicle may be the best choice for your current financial situation.
Buying a New Car Analysis
There is no feeling quite like buying a new car. Going into the dealership, being treated like royalty, and getting that first smell of new car leather represents a kind of feeling of success that many of us strive to obtain – until we have to start making payments after a month or two and the newness has worn out. After several months of car payments, higher insurance, the new car smell faded as a distant memory, and perhaps a few dings and scrapes along the way, many people will sit back and ask themselves how they fell for the dealership’s marketing ploy to spend every dollar they make in a single year on a vehicle.
After all, the average new car price in the U.S. is right in line with the median income for a single earner of around $31,000. Was it the 3-year, 30,000-mile warranty, the exceptional service from the dealership, or financing special that spurred you into putting yourself in the crunch with a new car payment for the next 6 years? Maybe you were driving an older vehicle such as the average age of the car on the road today of around 12 years and wanted to upgrade.
Regardless of why the irrational decision was made to buy a new car if you could not afford the purchase price but could manage making the payments over 6+ years, the opportunity cost of buying that car is probably greater than you think. For our analysis over the 20 years of buying a new car, we will assume the following:
- The monthly payment will be $530 or $6,360 per year for 6 years which is the average current loan payment and duration in the U.S.
- After the car is paid off for 6 years, we will assume the former car payment can be invested in the stock market at the historic rate of return of 10% until a new car is purchased which will offset the total net cost of ownership
- No maintenance costs will be assumed in the first 3 years of ownership as the car is covered by warranty
- After the warranty is expired, we will assume an average of $100/month in maintenance and repairs to cover any maintenance costs from oil changes, tire purchases, or major replacements indexed at 2% to represent inflation as well as the increasing likelihood of breakdowns and required repairs as the vehicle ages
- The vehicle will be driven until it reaches the average age of the car on the road of 12 years
- After 12 years, another new car will be purchased with the same assumptions as before
- However, the payments for the new car starting in Year 12 will be indexed at a compounded inflation rate of 2% per year of the initial payment in Year 1 to reflect higher overall selling prices in future years thanks to overall cost of living increases
- Similarly, maintenance costs will be indexed at a 2% inflation rate
Don’t worry about analyzing the rationality of every single assumption and keeping every detail in mind. The overall purpose is to take the big picture costs and incorporating some of the benefits of buying a new car every year compared to older, used cars, or leases. Many of these assumptions will be carried forward into the used car and lease analysis for consistency. Even if the numbers are not exact, each scenario should be generally comparable.
Opportunity cost of the new car payments
The first step in the new car analysis is to examine the opportunity cost of the annual payments. The actual vehicle payment for principle and interest is the largest expense in car ownership at $6,360 per year. In fact, this is nearly $1,800 more a year than the average used car even though these payments are made over 5 years and $1,200 more per year than the average lease.
However, one of the benefits of driving a new car is that once the car is paid for after six years, the owner can still drive the vehicle another 6 years payment-free until it reaches the average age of the vehicle on the road today of 12 years old. At this point in the analysis, the owner will upgrade their vehicle and the cycle will continue at inflated prices as the cost of living increases. Over the course of 20-years, should the car payments on the loan had been invested in the stock market at a 10% return, the future value of the payments would be around $295,000.
Total Opportunity Cost of New Car Payments over 20 years: ($295,000)
As mentioned above, one of the benefits of buying a new car and paying it off over 6 years is that it can still be driven another 6 years before it reaches the average age of vehicles currently on the road. Over the next 6 years, the payments that used to be made to the bank can be invested in the stock market to offset the cost of owning and operating the new car. If these amounts were invested, the individual would have nearly $130,000 that could be used to offset the cost of the new car payments.
Opportunity Cost when No Car Payment: $130,000
Net Cost to own New Car over 20 year: ($165,000)
New car maintenance and repairs
The next largest benefit of owning a newer vehicle is the maintenance and repair costs. For many new cars, a 3-year/30,000-mile factory warranty comes standard and will cover the costs of repairs should anything break within the allotted period of time or mileage.
Unless you are a road warrior that puts way more than 10,000 miles per year on the vehicle, chances are that you will have little out of pocket expenses in the first quarter of the vehicle’s life. Many dealerships will also throw in free oil changes and tire rotations, and other benefits that essential reduces the maintenance costs to a negligible amount for the first few years of new car ownership.
Therefore, in this analysis, no maintenance and repair costs will be assumed when the vehicle is less than 3 years old. After 3 years, we will assume $100 per month or $1,200 per year, indexed at 2% per year for maintenance charges. While a relatively newer car that is only four or five years old may not have $100 in maintenance and repair expenses every month, more than likely, they will have a few months that will cost the owner $1,000 or more to buy new tires or fix other miscellaneous mechanical issues.
Each year as the vehicle ages, we will assume an additional 2% more in costs reflecting the fact that as vehicles age, the become costlier to maintain as the risk of failure increases and the overall cost of parts and labor will increase with inflation.
Total Opportunity Cost of Maintenance and Repairs on New Vehicle: ($51,000)
Total Net Opportunity Cost of Purchasing New Vehicles: ($216,000)
Over the course of a 20-year period, purchasing the average new vehicle will have a total opportunity cost of over $215,000. Over even longer stretches of time, the total cost will compound even further and will end up costing fortunes. Some individuals who make the median income of $30,000 simply cannot afford to lose nearly 1/3 of their potential income per year to car payments when there are potentially cheaper options that will allow them to instead invest that money and eventually gain financial independence for themselves and their family.
Buying a Used Car Analysis
Let’s have a look at the numbers if a used car had been purchased instead of a completely new vehicle off the lot.
Purchasing a used car that is nearly 4 years old allows someone else to take the financial hit of depreciation. While this function is not even incorporated in the new car analysis above, the impact will negatively impact the overall “returns” of the decision to buy a brand-new car. However, the drastic effect of depreciation is evident in the purchase price of the average used car purchased in the U.S. of $19,900 which is over $11,000 less expensive than the average new car purchase of $31,000. This means that after 3-4 years, the value of the car has dropped over 35%.
Unless you have an abnormally high income, very few individuals can continue to take this kind of financial hit repeatedly over the course of their lives. Purchasing a used car, by contrast, allows some other unsuspecting buyer to take the majority of the financial hit for you. While a vehicle that is four years old does not have the manufacturer’s standard warranty or the perks that the dealership offers, in this scenario, you would have over $11,000 in your pocket which will more than offset these perks. After all, the reliability of vehicles on the road today is unparalleled, and as long as you perform scheduled maintenance, the vehicle should continue to run well for decades to come.
In the U.S., the average used car purchased results in payments of around $381 per month which equates to around $4,572 per year. This is nearly $1,800 less per year compared to buying a new car. Additionally, the average term for a used car is around 5 years which is less than the 6-year term for new cars. One less year of payments, coupled with the smaller monthly payments, makes buying a used car substantially more appealing for the financially savvy who do not mind driving a slightly older car.
Opportunity cost of the used car payments
The first step in the used car analysis is to examine the opportunity cost of the annual payments. The actual vehicle payment for principle and interest is the largest expense in car ownership at $4,572 per year. Since we are assuming the used car is four years old, the owner will have the ability to drive the vehicle for another eight years before it reaches the average age of the car on the road and it is time to upgrade to another car that is only four years old. If he or she takes out the average used car loan over five years, they can still drive the vehicle for 3 years payment-free until it reaches the average age of the vehicle on the road today of 12 years old.
At this point in the analysis, the owner will upgrade their vehicle to another four-year-old car and the cycle will continue at inflated prices as the cost of living increases similar to the new car analysis. Over the course of 20 years, should the payments made on the used car been invested in the stock market at a 10% return, the future value of the payments would be around $230,000 which is nearly $65,000 less than the new car discussed above.
Total Opportunity Cost of Payments over 20 years: ($230,000)
Paying down the difference in the loan
As previously discussed in the new car analysis and mentioned above, one of the benefits that should be incorporated is the investment of the payment once the vehicle is completely paid for. In our analysis, a four-year-old vehicle can still be driven another 3 years payment-free before it reaches the average age of vehicles currently on the road and it becomes time to upgrade to another used vehicle. Over the next 3 years, the payments that used to be made to the bank can be invested in the stock market to offset the cost of owning and operating the used car. If these amounts were invested, the individual would have nearly $88,000 that could be used to offset the cost of the used car payments.
Additionally, the average payment for a used car is nearly $1,800 per year less than a new car. This amount could theoretically be invested in order to offset the cost of buying the used car which makes the economics of used car purchases even better.
Opportunity Cost when No Used Car Payment: $88,000
Opportunity Cost of Lower Used Payment: $78,000
Net Cost to own Used Car over 20 year: ($142,000)
Net Cost of Used Compared to New Car: ($64,000)
Maintenance and repair
Perhaps the biggest con most people assume in buying a used car is the maintenance and repair costs. Part of the draw that dealerships use to incentive people to overpay for new cars is the warranty and security of not having to worry about out of pocket maintenance and repair expenses early in the car’s life.
Used cars, by contrast, require the owner to pay out of pocket for services such as oil changes, tire rotations or replacements, and major repairs that could cost thousands of dollars. Contrary to new car purchases where the warranty covers the maintenance and repair expenses in the first three years, we will assume the same maintenance costs for a used car in year 1 as we do for new car in year 4 since at this point, they will be both 4 years old, offering consistency to the analysis.
Therefore, we will assume $100 per month or $1,200 per year in maintenance expense for a used car and escalate this amount 2% per year until another used car is purchased and the maintenance expenses drop back down to reflect the decreasing risk associated with a newer vehicle. As such, the opportunity cost of the repairs and maintenance is $80,000 over the course of a 20-year period. In all, the total maintenance and repair cost for a used car in this analysis is nearly $25,500 over the course of ownership compared to a little less than $20,000 for new cars thanks to the warranty for the first 3 years. The opportunity cost for repairs and maintenance cost assumed is nearly $30,000 more than for new cars as these out of pocket expenses could have been invested over a longer period of time.
Total Opportunity Cost of Maintenance and Repairs on Used Vehicle: ($80,000)
Total Net Cost of Purchasing Used Vehicles: ($222,000)
Total Net Cost of Purchasing Used Vehicle Compared to New Vehicle: ($144,000)
Net Benefit to Buying Used Car vs. New Car: $72,000 (New: ($216,000) vs. Used: ($144,000))
Buying a new versus used car
In summary, the total net opportunity cost for buying a new car is $216,000 in this analysis compared to $144,000 for buying a used vehicle. The difference is primarily due to the fact that the average car payment for a new car is much higher compared to a used car payment and the average loan duration is a year shorter because of the lower price of used cars. If the excess payment and additional year of having no car payment is invested at a 10% rate of return, this would result in lowering the Total Net Cost of Purchasing a used Car.
Obviously, the analysis uses standard assumptions for both new and used cars which may not be reflective of the actual costs of ownership. The biggest variable which could cause differences relates to maintenance and repair costs. If a car buyer is able to buy a four-year-old vehicle and never have major mechanical issues over the course of ownership (which is reasonably likely), they will come out even more ahead as the assumption of over $1,200 per year will end up way higher than actual maintenance and repair costs. This is because routine oil changes, tire rotations and alignments will only cost a few hundred dollars compared to replacing a transmission, starter, or engine.
More than likely, the 3-year warranty on a new car will never be needed and there will be no realized benefit. This is why the dealership is willing to include this with the vehicle purchase as they know the likelihood of losing money is fairly slim and offering this perceived benefit will result in higher sales.
In this analysis, purchasing a used car is by far the most economical choice even considering higher maintenance and repair costs. This is due to the fact that the loan is over a shorter duration and the payments are much lower because the value of the used vehicle is around 35% less after 3 years of depreciation compared to when it was first driven off the lot.
Comparatively, new cars decrease in value by more than a third after 3 years of ownership, the loans are typically over a longer duration due to the higher price, and the payments are much higher. While savings for maintenance and repairs do exist for new cars, the benefit is mitigated by all of the other factors working against the benefits of owning a new car. Additionally, odds are there will be little repair required in the first few years anyways.
Purchasing a Leased Car Analysis
Another option to evaluate is the possibility of leasing a vehicle. With a lease, you receive the luxury of driving a newer vehicle that you are able to return after a set period of time – typically, two or three years depending upon the duration of the lease.
What is a lease?
Essentially, with a lease, you are renting the car longer term for the cost of the depreciation and finance charges, as the lease payment is theoretically based on the estimated residual value at the end of the lease as well as financing profit that are baked into the payment. Net, the overall payment in driving a new lease results in a much lower monthly payment compared to purchasing a new car. Many individuals who could not otherwise afford a large down payment or the total cost of the vehicle outright opt to lease and continually renew to drive new vehicles. If this is the case, pretty severe financial consequences will result if your goal is to build wealth longer term.
What are the benefits of leasing?
The benefits of driving a new car lease are similar to the benefits of always driving a new car. Much of the costs are typically covered in the lease or under the manufacturer’s standard warranty which applies to new vehicles. Similar to new car purchases, leases may include ancillary benefits such as free oil changes, tire rotations, and the other required maintenance similar to that which is included with purchasing a new car. However, this may not be the case for all leases unless a maintenance package is also purchased.
With a lease, the operator has the ability to continually trade-in their current vehicle every two or three years in exchange for either a new model or a different type of vehicle should they desire a larger or smaller ride. Additionally, lease payments tend to be much less than payments on the equivalent brand-new car purchased outright. The average monthly lease payment is around $430 per month compared to the average new car payment of around $530 per month. Depending on the lease stipulation, a down payment could be required up front on signing.
However, with a lease, the individual will always have a payment to make. They will never experience not having a car payment to make that could be invested elsewhere like they would when they eventually pay off the new or used vehicle over a period of time. By contrast, they will have lower monthly payments, and theoretically, the difference in cost between buying a new car on payments and taking out a lease could be invested to offset the cost of the lease.
Maintenance and repairs on leases
Those who lease their vehicle will also have the convenience of worrying less about maintenance and repair costs, and as long as they stay within the specified mileage and meet the ordinary wear and tear clause in the lease, there should be little out of pocket expenses other than gas and insurance. Should more miles be put on than the lease term permits, charges up to $.25 per mile over the limit could be assessed when the vehicle is returned.
Opportunity cost of the lease payments
As discussed, the average lease payment in the U.S. is around $430 per month with a down payment of around $400 due at signing. In the lease analysis, we will assume the average cost of a new signed lease increases at 2% per year with inflation. Therefore, when the lease is renewed after three years, the lease and down payment will be renewed a little over 6% higher than the previous lease, resulting in higher lease payments with each new lease. If you were to invest the down payment and lease payments in the stock market at 10% over a 20-year period, you would have nearly $404,000. Unlike new and used cars, we will assume the maintenance costs will be negligible since most expenses should be covered under the standard warranty.
Total Opportunity Cost of Lease Payments: ($404,000)
As mentioned above, one of the benefits of leasing a car compared to purchasing a new car outright is the lower monthly payments. In fact, the average monthly lease payment is nearly $100 per month less than the average monthly new car payment. However, after the 6th year of payments on the new car, the vehicle has been paid off, and another new car is not purchased until the car reaches the average age of vehicles on the road of 12 years old.
Therefore, even if you invested the $1,200 per year in savings, the lease payments in the years where the new car would have been paid off eliminates this benefit. This is because even though you may be gaining ground while making payments on a lease versus new car payment, when the new car is paid off, you are still paying the full cost of the lease or over $6,000 when you would have no payments on the new car purchase. Granted, you would be driving a brand-new car with the lease while you would be driving a 6 or 7-year-old car that is now paid off in the new car analysis.
Regardless, from a financial perspective, you will always have a lease payment while you can eventually eliminate your car payment if you bought a new or used car and the difference in payments could be invested. Therefore, it is not appropriate to include the perceived benefits of a lower lease payment because this is more than offset by the fact that it is in perpetuity, and there is never a break in payments.
Total Net Cost of Lease: ($404,000)
In conclusion, here are the final, total opportunity costs of purchasing a new car compared to a used car and a lease:
New Car: ($216,000)
Used Car: ($144,000)
Lease: ($404,000)
Leasing a vehicle is the most expensive route
Over a 20-year period, the most expensive way to operate a vehicle is through a lease. However, you must also consider the ancillary benefits of driving a lease such as less maintenance hassle and continually driving new vehicles that may not otherwise be affordable to drive. With that said, some wealthy individuals who can clearly afford whatever they desire may opt to lease so they have the well-deserved benefit of driving a new, luxury vehicle every few years without taking the huge hit on depreciation that they would if purchased outright. However, in both cases, these benefits come with a steep price that can be absorbed by wealthier individuals compared to most average car buyers.
Buying a new car
Similarly, new car purchases can be quite costly; however, unlike leases, the pain of making monthly payments can be eventually alleviated when the loan is repaid as long as they are kept until they reach the average-aged vehicle on the road. In the first few years of ownership, new cars will have negligible maintenance expenses as most issues will be covered under warrant similar to leases. As they age, the maintenance costs will continually climb until another new vehicle is acquired.
The most economical way to buy a car
Purchasing a 4-year-old used vehicle offers the most economical way to operate a vehicle; however, with this method, you may see financial benefits, but some of the trivial benefits such as that “new car smell” and the factory warranties with a new vehicle purchased will not be realized. There will be considerably higher maintenance costs, and in this analysis, there will be a higher turnover cycle as the vehicles will be upgraded after 8 years when the vehicle hits 12 years old.
In conclusion, the goal with purchasing a car should be to minimize the overall expenses or right-size your car purchase to match what can be afforded. After all, any money put into vehicles could be put to a better use through other investments to create wealth. Therefore, the goal should be to eliminate any car payments as soon as possible in order to invest that payment elsewhere. Contrary to investing the money, purchasing a vehicle that continually depreciates every year makes building wealth much harder as the money put into car will eventually be worth $0 over the very long-term.
Leasing a car is by far the worst decision unless your financial position permits you to experience the luxury of constantly driving new vehicles and paying for that luxury. However, for the vast majority, purchasing a used car, holding and driving that car for as long as possible before upgrading to another used car is the best financial decision to drive a reliable, relatively less expensive vehicle.