Car Shopping 3 - Cost Decisions

(Note: This was originally part of the first post on Car Shopping - but I decided to break it out as a separate entry)

Making It Into a Cost Decision

The question I really need to answer, then, is "At what point does it make sense to put that money into a new car, instead of using it to extend the life of an older car?" The simple answer goes something like, "Well, at the point where the annual cost of the older car exceeds the annual cost of a new car." But here's the catch: How do you determine the annual cost of a new car? Is it the amount of money you lay out for the car in one year, including loan payments? What if I take out a 3 year loan or a 5 year loan? Or what if I pay cash for the car up front? How do I normalize the annual cost of owning the new car so that comparing it to the annual cost of owning the old car makes sense? It turns out that the simple answer wasn't that helpful until I did a bit more thinking about.

Of course, there are other annual costs that typically increase or decrease for a new vehicle, like insurance (goes up), fuel (goes down), washings (theoretically the same, but I bet I wash a new car more often, so increases), oil changes (same), license renewal (goes up), etc. These can all be quantified and expressed reasonably as annual costs (just go look up your most recent insurance bills and credit card statements). But how do I come up with the annual cost associated with the "value" of the car itself?

I've given this some thought, and I think it goes something like this: A more valid way to get an annual “value cost” for a car would be to take the amount you Pay for the vehicle (P), subtract the amount you get when you Sell the vehicle (S), and divide that by the number of Years you keep the vehicle (Y), or (P-S)/Y. What this tells you is how much of the vehicle's “lost value” you used up each year you owned it, where that “used up value” is the difference between what you pay for it and what you sell it for in the end. If you never sell it and just run it into the ground, then you effectively sell it for zero. But you tend to own a vehicle like that for a LONG time, and we’ll see later why owning a vehicle longer can be a good thing.

Applying that formula, here’s an example based on my ’98 Subaru Forester: it cost me around $20,000 when I bought it in February of '98. I've owned it for 9 years and a little over 5 months (let's just say 10 years to make the math easy, though). If I were to sell it on the open market right now, I might get $4,000 for it. ($20K-$4K)/10years = $1,600/year in "annual value cost" (or “depreciation”). That's pretty straightforward, and for my old car the numbers are relatively easy to come by. How do you compute this for a car you are thinking about buying when you don't know 1) how long you'll be keeping it (Y from the equation above) or 2) how much you'll sell it for if you ever do (S from the equation)?

Depreciation is NOT a 4 Letter Word

What you do is you essentially guess. But thanks to modern science, you can make a fairly educated guess. I’m using what they call a “depreciation calculator”. Depreciation, which I referred to moments ago, is the "used-up" value of the vehicle at any given time (that difference between what you paid for it some years ago and what you could sell it for at some later time. Today, for instance.). It turns out that this idea of "used-up" value comes up quite often in the world of finance, and they forecast depreciation for lots of things all the time (not just cars). But since we are talking about cars specifically, I looked for and found this handy calculator online, which for purposes of the comparison I'm making, seems as valid as any OTHER way of guessing at a car’s future value. (In reality, this is a somewhat better than average guess, since it's based on the way that cars have lost value in the past. Given the number of cars that have already been and gone, this means the guess is based upon a pretty significant sample size, and consequently, this guess ends up being pretty darn good.)

So now we know the value of the new car we are buying (let’s call that $25,000), and we can guess how long we plan to keep the car. If you’re not sure, it’s reasonable to use the length of time you kept your LAST car (10 years in my case). We can plug both of these into the calculator to get an estimate of the depreciated value of the new car 10 years out, which turns out to be around $4,700, a loss in value or depreciation of $20,300 (I’m rounding a bit because I like the math to be as easy as possible). In other words, the calculator is guessing that a $25,000 car purchased today would sell for $4,700 in 10 years, losing $20,300 in value, or, if you divide by the 10 years, at an annual value cost of $2,030. Just to be crystal clear, lets go back and plug the numbers into that formula from above, and you’ll see that you get ($25,000-$4,700)/10Years = $20,300/10Years = $2,030/year of lost value.

Of course, there’s nothing stopping me from checking to see what would happen if I kept the car only 5 years (or any number of years). What you’ll see if you do that is that the estimate of the annualized used up value of the vehicle (or deprecation) is about $2880 for a 5 year old car. You’ll notice that’s quite a bit higher than it was at 10 years. If you calculated this for each year 1-10, and then compared those numbers (by plotting them on a graph as I have above, for example), you would notice an interesting trend: the longer you keep the car, the lower that annualized loss of value gets (the orange line on the graph). What this means is that a newer car bleeds more dollars in value per year (the red line indicates the $'s in value lost per year as computed using the calculator) than an older car, and that as the car gets older, it loses a smaller number of dollars in value each year (pretty much – in actuality, if you look closely at the red line, you'll see that year 4 loses slightly more cash value than year 3. I’m not sure why. Perhaps it’s because this is when most cars outlive their factory warranties?).

Back to Why We Are Here

While all that is riveting, all I really wanted to know was whether it’s more or less expensive for me to keep my ’98 Forester than to buy a new car. And from what we discussed earlier, there are some other annual numbers I’m going to need to make a good comparison.

So lets review. Here’s a table that captures the list of annual costs for my ’98 Forester and some fictionalized $20,000, $25,000 and $30,000 vehicles (you will probably have to click on this image or open it in a new window to make it large enough to read easily):

First, let me tell you exactly what I'm comparing. I'm comparing the annual cost of keeping my Forester for another year to the annual cost of buying and owning a new $20K, $25K or $30K vehicle that I plan on keeping for 5 years.

Note that although there is a line (line 10) for Maintenance (repairs that older cars typically need and that the owner has to pay for, but that newer cars typically don't need or that are at least covered by the warranty), I've set that line to zero for my '98 Forester. This allows me to use the Savings amounts shown on the bottom line of the chart as a guide telling me the maximum maintenance costs I could pay in the next year on my Forester before it's costing me more to keep my old car than it would to own a newer car. IE - look at cell C13. What this tells me is that if I pay more than $1577 in maintenance on the Forester this year, it will have cost me more on an annual basis than it would have cost me to own a new $20,000 vehicle I plan to keep for 5 years. Remember what happens if you keep a car longer, though. If I recomputed this chart assuming that I'd be keeping my new vehicle for 10 years, the "maintenance break point values" would be lower - making it more likely that trading in the Forester for a new vehicle would make sense financially.

That's all for this installment. Apologies if you don't enjoy math or finances and if you felt like this turned into that. But if you DO enjoy that sort of thing, well then - you're welcome!