This is actually a post about finance, so keep reading, even when it seems to be all about cars!
I have a 2009 BMW M3 Convertible. It chews through a tank of gas at least once a week. At Aus prices of $5.30 a gallon, it’s not cheap.
But, it is a heck of a lot of fun 😉
My wife counterbalances: she owns a 2009 Lexus 400 Hybrid. She grudgingly refills about once per month … sometimes I think that she must push the car up hills just to avoid having to refill early.
But, she also thinks playing Gas Roulette is a heck of a lot of fun.
My first car (actually second) in the US was a Mustang GT convertible. It had a monster V8 engine, sounded great with the roof down. Needed a gas station on every corner. Drove like a tank.
It was also a heck of a lot of fun.
But, it was the dumbest car I ever owned …
There was an air-scoop on the hood of the car. The idea of an air-scoop is to suck in extra air to the carburetors on the car to keep the engine happy.
An air-scoop is supposed to be a performance enhancement …
… except, it sticks up out of the hood, so it destroys some of the air-flow, increasing drag, actually decreasing performance and fuel economy.
But, the engineers are made to make the hard design choices: do the increases in performance (extra efficiencies in the carbies) offset the losses (extra drag)?
Naturally, the engineers are experts at what they do so we can trust them to make the right decision. Right?
Well, I would have thought so … until I bought my Mustang. You see, I’m a layman, but even I can tell that:
1. The Mustang has NO carburetors (neither does any modern car), nor does it have any turbo-chargers or anything else that required the injection of air that a hood air-scoop would provide.
2. Now, here’s the killer (just in case we have any engineers out there to dispute my point 1.): the scoop has no air-holes in it.
That’s right, it’s simply an imitation airscoop. A fashion accessory.
As a marketing device, simply designed to make me buy the car, it worked brilliantly!
In other words, it reduces the performance of the vehicle!
Now, don’t get me wrong, the Mustang performed well, and was fun to drive, but didn’t perform better than ‘advertised’. It’s (partially) a marketing con.
My wife’s hybrid is also (partially) a con.
She paid a lot of money to have a hybrid that clearly does save money. But, just like the Mustang, it is designed to perform less than optimally, I believe just to build a marketing story to help sell the product.
The Lexus Hybrid includes a dynamic dash that shows the power flow between the gas engine, the wheels, and the electric motors.
If you don’t understand how a hybrid works check out this video:
In essence, it’s a closed system that uses electric motors (and batteries) to augment the traditional 6 cylinder gasoline engine:
– The gas motor drives the vehicle at all times except when the car’s at rest
– It saves gas simply by ‘switching off’ the engine whenever the vehicle stops.
– The electric motors then restart the engine as the car begins to move (like ‘jump starting’ a car by pushing it downhill … you can even feel a very slight ‘jump’ as the engine kicks in)
– The gas engine then takes over again when the car is moving at a mile or two an hour
– The electric motor’s batteries never need recharging: they are simply charged by an alternator and whenever the car is coasting or braking (it’s called ‘regenerative braking’)
Now, just like the Mustang’s air-scoop, the problem is in the ‘performance enhancement’ of the recharging system. For example, let’s take a closer look at regenerative braking:
Whenever the car is coasting down a hill, it needs to be able to retain as much momentum as possible to help carry it up the next hill, otherwise you have to hit the gas pedal that tiny bit earlier.
The regenerative braking takes a bit of the car’s energy and turns it into electricity, creating additional friction which slows down the car. So you do have to hit the gas pedal that tinier bit earlier.
If you know your physics, introducing this extra step MUST reduce overall efficiency hence increase gas usage.
So, the hybrid works (because when you have to come to a complete stop, such as at a traffic light then you might as well put some energy into the batteries rather than simply heating up the brake pads), but it would work BETTER by turning OFF its regenerative braking ‘performance feature’ when coasting.
But, then that pretty display (image at top of post) wouldn’t be nearly so pretty 😉
What does this have to do with finance?
Well, your 401k is pretty much like my wife’s hybrid!
Sure, it helps to save money. Sure, it’s employer matched. Sure, it’s tax-protected.
But, it could be a lot BETTER simply by turning OFF some of the ‘performance enhancements’ that they’ve added to make the products SEEM more attractive to both employers and employees e.g.:
1. Choices of funds: it has been shown time and time again that long-term buy/hold investors would be better off either selecting their own stocks (if they have the necessary desire and aptitude) or simply putting their money into an ultra-low-cost Index Fund (e.g. S&P500).
All those other high-fee fund choices perform more poorly over the long run. So, why not eliminate them from the fund choices offered? Simple: marketing!
2. Additional services: Fund managers, and the guys that put together benefits plans for employers, offer all sorts of freebies & incentives to the employer to encourage them to buy THEIR funds and services; the problem is, these help the employer – not you. Worst of all, they cost you money. So, why not eliminate them? Simple: marketing!
So, a 401k performs a lot worse than it should, just so the marketing guys can pitch a better story.
Forget the Lexus Hybrid – and, your 401k – they don’t deliver on their promise.
Instead, hop into a BMW M3 – or, direct stocks, real-estate, or business investments – and, supercharge your life.
Unlike my wife’s Lexus Hybrid, or your 401k, their promise – living a little on the edge, but being thrilled with the results – is delivered in spades!
Marketing and performance, for once, are totally aligned 🙂
You’re financing a depreciating asset: so, as the car goes DOWN in value over time, your investment in it is going UP, payment by payment.
The frugal way is to buy a used vehicle and run it into the ground.
But, what if you like and can afford to buy a ‘certain quality of car’?
Well, I would never buy a new one, and I would usually buy one of a lesser standard than I can afford, because cars do depreciate and are simply NOT an investment (even when you think they are).
Now, this is a blog for aspiring MULTI-millionaires, so I am going to spare you the usual reasons for buying used rather than new [hint: something to do with depreciation vs future resale value curves], because you can actually afford to buy new!
No, what I have to share works on the assumption that you can afford to buy a new car, but you do have budgetary contraints: i.e. a Number that has to fund your required standard of living for life. You can’t afford (literally) to have your money run out before you do!
If you’re either too rich or too poor for that to apply then this post [AJC: actually, my whole blog] does not apply to you …
But, this post DOES apply if you have a new car budget, be it a new $250,000 Ferrari 458 Italia [yum] or a new $11,000 Chevrolet Aveo [yuk]:
No, the problem is that IF your mindset is to buy a new vehicle, then how do you feed your desires in 3 to 5 years when your ‘new’ car becomes just another ‘used’ car?
However you justified the ‘new car’ purchase – new car smell, new car warranty, new car reliability, new car status – in just 3 to 5 years, the ‘gloss’ will have well and truly worn off, and you will be in exactly the same position as you are in today:
You will want ANOTHER new car!
And, you will want another one – similar to the first one (or better!) every 3 to 5 years thereafter, until you are too old to care about cars anymore … and, take it from me, you will be pretty old when THAT happens 🙂
That’s why, when I ask people to calculate their Number, I ask them to come up with their required annual spending plan (and, multiply by 20), then add in any one-off costs: usually just houses plus your first post-retirement vehicle purchases (what’s your chances of your spouse settling for less than you?).
But, for non-annual repeat purchases (the annual ones should already be in the budget … get it?), I simply ask them to calculate a lease / finance rate for the occasional purchases they are interested in (e.g. cars, around the world trips) as though they were going to finance those purchases, and build that cost into their required annual spending plan (basically, their expected retirement living budget).
This will include your replacement vehicles … the ones that you will need to buy after the first 3 to 5 years in retirement.
How to calculate the correct amount?
It’s actually quite simple:
1. Choose the car from today’s model lists that seems to be likely to suit your purposes from a new car pricing web-site.
Right now, I drive a BMW M3, my next car is likely to be no less expensive. But, I actually want more, so I will build in the cost of a Ferrari 458 Italia (that should pretty much cover me for any other car I decide to ‘graduate’ to as I get older, e.g. top-of-the-line Mercedes). If I didn’t aspire to more in the future then I would use the current list price of a 2011 BMW M3 as my ‘base’.
2. Find the current price of a 5 year old Ferrari F430 (because the 458 Italia wasn’t around 5 years ago) from a used car pricing web-site.
3. Subtract 2. from 1.
4. Find an online auto leasing calculator and use 3. (i.e. the amount over the trade-in of your current auto that you will need to come up with every 3 to 5 years) plus the age of the vehicle that you selected in 2. (i.e. how often you expect to want to changeover cars) plus select an interest rate that is likely to reflect long-term averages for investment returns on your remaining money (6% – 8% is plenty)
5. The calculator should then spit out the monthly amount that you need to add to your required annual spending plan
Now, why should you choose “an interest rate that is likely to reflect long-term averages for investment returns on your remaining money” rather than the expected cost of FINANCING such vehicles?
Didn’t you read the opening paragraph of this post?!
You’re not financing anything, you are SAVING to replace you current auto (or, the one that you first bought when you reached your Number and stopped working), and you are building in the LOST OPPORTUNITY COST of having your cash tied up in your cars rather than sitting in your investment account working for you, and you are accounting for inflation pushing up the price of your future, future, future replacement vehicles.
What if you make a mistake with you future financial position or the price of your next car?
Well, you simply hang on to the cars that you already own for a while longer … or, ‘down-size’, if you have to …. who says that you HAVE to replace your cars every 3 to 5 years?
Now, you can apply this same strategy before you retire: it’s called saving up for your next car (and, the one after that, and the one after …) rather than financing it 😉
PS If you run these numbers again, here’s an even better strategy:
Instead of buying a new car, buy a slightly used – but much better – make and/or model of vehicle. Because I’ve found that cars – just like radiation – have a half-life (but, different for each brand of vehicles) and some depreciate 20% as soon as you drive them off the lot, you may find that you can buy a much better car for the same money albeit 1 to 2 years old. If you choose well, you may find that you are (a) driving a better vehicle and (b) can keep this vehicle for another 4 to 6 years before replacing it (because ‘classic cars’ tend to remain classic long after your shiny new American/Japanese/Korean production-line ‘beauty’ has well and truly gone off the boil). Plug a 6 to 8 year replacement cycle into you calculator v the 4 year one that you chose for new and see what that does for your retirement plans!
What do cars and radioactive material have in common?
Well, besides each being a potential environmental disaster if not managed well … they both have a half-life:
– For radioactive material, it’s the period of time for a substance undergoing decay to decrease by half,
– For your car, it’s the time it takes for you to lose half your money!
This is because the largest cost of auto ownership is not the finance charges, the taxes, the gas that you put in the tank, or even the tires or repair costs … it’s a largely ‘hidden’ cost called depreciation.
You see ‘depreciation’ when you sell the car as The Amount You PaidlessThe Amount That You Get Back.
Even the amount that you get back helps to hide the true depreciation cost because you will often trade in the vehicle and the dealer might ‘sweeten’ his offer by giving you a higher trade-in figure than the car is really worth … but, what he is really doing is giving you a discount on the purchase price of the new car (a discount that you may well have received – or exceeded – even if you didn’t offer a trade-in).
Even if the 15% to 20% p.a. depreciation claimed by Debt Free Bible is true, what effect does that have on the value of the vehicle?
The chart shows if you paid $25k for your new car, you can only get $12,800 if you sell it after 3 years, even if you decide to hang on to the car, it has cost you $25,000 – $12,800 = $12,200 …
… or, $4,067 a year!
[ AJC: And, don’t forget all of those other costs that we mentioned: “the finance charges, the taxes, the gas that you put in the tank, or even the tires or repair costs” 😉 ]
So, how accurate is that “15% to 20% p.a. depreciation claimed by Debt Free Bible”?
Well, a paper published by the IAES, which evaluated the depreciation rate of 15 automobile brands available in the USA for the years 2000-2004, yielded 5 tiers of depreciation rates:
Tier One: Honda and Lexus with an average annual depreciation rate of 13.4-14.1%.
Tier Two: Volkswagen and Toyota with an average annual depreciation rate of 16.5-16.8%.
Tier Three: Nissan, Mercedes, BMW, Hyundai, and Mercury with an average depreciation rate of 18.9-21.2%.
Tier Four: Chevrolet, Chrysler, and Saturn with average annual depreciation rates of 25.4-27.5%.
Tier Five: Dodge, Ford, and Buick with an average annual depreciation rate of 31.1-32.6%.
Now, using these rates, I have calculated the Half-Life of each brand for you, simply by using the Rule of 72 [AJC:divide the depreciation rate into 72; the answer is the number of years it will take to halve the purchase price] ….
Use this table to find 7 Million 7 Years Patented Half-LifeFor Your Next Car:
Honda / Lexus: 5 Years 3 Months.
Volkswagen / Toyota: 4 Years 4 months
Nissan / Mercedes / BMW / Hyundai / Mercury: 3 years 7 Months.
Chevrolet / Chrysler / Saturn: 2 Years 9 Months.
Dodge / Ford / Buick: 2 Years 3 Months.
Using this information, you could do some very fancy tables about the break-even point of spending more to buy a new (say) Lexus instead of a new (say) Nissan – factoring all the other costs of ownership, if you want to get real fancy – given that you have a couple of years worth of depreciation to play with …
… rather, I would like you to see that you are far better off buying a second-hand vehicle of the type that you are after, so that you can pay half-price 😉
You do this, simply by buying a 4 year, 4 month old Volkswagen, or a 3 year, 3 month old Buick, etc.
And, even if you were determined to buy new, you are still probably better off buying a slightly ‘better’ brand used – even if it means going up a tier or two – than you are in buying a new ‘standard’ brand auto.
Sorry GM and Ford, but you are in DEEP trouble, because you simply aren’t competitive!
I’m rapidly becoming the ‘Dear Amy’ of personal finance blogs (don’t let this stop you, I actually love receiving these types of e-mails!); Tam asks:
I am working to pay off my expensive debt which should be paid off in the next six to eight months. However, my dilemma is I LOVE cars. I want to finance (w/ a sizable down payment) a new car after my debt is paid off. I’m trying to talk myself out of it because I know I should be putting that money toward my financial goals but I just keep saying that if I can get this car, then I won’t want anything else and will be satisfied. Deep down, I know this is not true because three years later, they’ll be another new car that I will want. What can I do to stop myself from buying this new car (Nissan 370Z Roadster)?
Man, what can I say?!
I could point Tam to the post that said not to buy a new car, or to the one that said not to finance, or even to the one that said not to spend more than 5% of your net worth on ‘stuff’ (including your car).
I’m guessing that any one of these would be reason enough not to buy the car … instead, I just offered Tam the following advice:
Here’s how it works. Every time I find myself in a situation where there appears to be no solution that will make everyone happy, I ask myself three questions:
What are the consequences of my decision in 10 minutes?
In 10 months?
And in 10 years?
The answers usually tell me what I need to know not only to make the most reasoned move but to explain my choice to the family members, friends, or coworkers who will feel its impact.
I can definitely see how these questions could apply to personal finance: before you make your next major financial decision, take some time out to ask yourself how that decision to [insert financial decision of choice: buy, sell, finance, change, etc.] could affect your life in 10 minutes / 10 months / 10 years.
Chances are that you will change your mind 🙂
Tomorrow, I’ll show you an even more powerful idea that will go hand-in-hand with 10-10-10 to “totally transform” your personal spending habits …
I often get comments from new readers asking where to start: so, I start from the premise that living frugally and working for 20 to 40 more years to retire on the equivalent of $15,000 today isn’t what you had in mind? If it is, then this blog isn’t for you 🙂
OK, so you’re still reading … great! In that case, the place to start is to work out what you want from your life and how much it will cost you to get it; here is a site that shows you how to work all of that out: http://www.shareyournumber.com/ Visit it (and, join the Community) … not only is this site totally free, I promise that it will be truly Life Changing.
Once you confirm that you do need to make $7 million in 7 years or $3 million in 10 years (or anywhere in between) then you’ll probably want some ‘quick start tips’; well, let’s start with your greatest expense: your house. This post – if you follow all the backlinks – will tell you all you need to know to make sure that your house actually HELPS you get rich(er) quick(er) instead of poorer: http://7million7years.com/2009/01/12/how-much-house-can-you-afford/.
If you’re still with us after that, then sign up for e-mail updates and trawl through the site to see what you can find, just like this guy did …
I’m glad that some people still rummage through my older posts, as the principles of money don’t age (reference the Richest Man In Babylon, for example) …
… so, I was pleased to have this opportunity to renew this discussion when John commented on this post about cars:
I know it has been over a year since you published this but I was wondering if you could comment on a few calculations I did after reading this post. My disagreement is mostly with the Finance Vs Cash option. The buying a used car part I totally get.
Let’s say I wanted to buy a car with an MSRP of 30,000. If I put 10% money down and get a loan of 27000 for 5 years at let’s say 5% APR. At the end of 5 years I will end up paying 33,571 for the car. If I had paid in cash I would have paid 30,000 for he car. The depreciation on the car would be the same in both cases. So I ended up paying 3,571 more for the car by choosing to finance it instead of paying cash.
But here’s the thing, by financing the car, I also ended up with 27,000 of cash which I can invest elsewhere. To recover the extra 3,571 that I’ll have to pay on interest for the loan, all I need to do is to put this 27,000 in an investment that can give me an APY of 2.52% only, which is not very difficult to find at all.
This suggests that buying with cash, even for a depreciating asset, does not make all that sense. Am I missing something here?
John is basically putting forward the idea of applying Cash Cascade principles to your car … and, given the parameters that he has set, John is absolutely right: it would be better to finance your car and invest the cash elsewhere …
… at least, in principle.
However, in practice, I’m not so sure that the Cash Cascade actually would suggest that you DO finance the car.
Reason # 1 : It’s unlikely that you will see 5% APR on a auto loan
5% APR car loans are not unheard of, but they are relatively rare; MSN Money cites the current national averages for auto loans as:
Low – 3.99%
Average – 6.18%
High – 10.49%
So, while auto loans as low as roughly 4% (an internet only ‘special’) are available, most are in the 6% – 10% range; and, don’t forget to factor in any added fees!
Of course, you MAY be able to take a 5% HELOC on your house to raise the cash for the car, but I wouldn’t recommend a short-term loan (i.e. a HELOC) for a long-term use (i.e. financing your car over 2 to 5 years) because the bank can change the terms – or even cancel your HELOC – whenever they feel like it. Then you might be stuck with getting a more conventional loan at a higher rate (there goes your 5% loan!).
On the other hand, a refi may do the trick … but, you need to watch both the 25% Income Rule and the closing/refi costs, which are likely to push you well over the 5% if amortized over the expected life of the car loan (you’d be crazy not to have a 2 to 5 year loan payback expectation).
Reason # 2 : It’s likely that you can beat a 5% APR auto loan
This seems to contradict Reason # 1, but doesn’t …
… you see, if you do find a 5% APR loan, it will most likely be offered by an auto dealer. However, the chances are that it comes with a catch: the car isn’t discounted as much as it could be!
A low (or even zero) APR loan is a very common manufacturer / importer / dealer incentive … but, they do a deal with their finance company (often manufacturer-owned, like GMAC) whereby they pay the differential interest rate for you and up front. Back to the catch: they load the price of the car to offset the pre-paid interest component. Sneaky, huh?
Reason # 3 : Even if you can’t beat the 5% APR auto loan you’d better have the cash ready
But, let’s assume that you go to the Pentagon Federal Credit Union for the only 4% APR rate that I could find that wasn’t loaded with fees, and they do give you the loan …
… you had better have the cash ready to buy an investment reasonably quickly.
If you don’t have already have the cash saved up then you should be prepared to save up until you have the lump-sum cash then decide if you want the car only or both the car and the investment. No point borrowing money for the car and trying to save up for an investment … unless, you really, really, really need the car right now! 🙂
… oh, and if you’ve read all the way to here, then you might want see what my 7 Millionaires … In Training! are up to; kind of like American Idol Meets The Apprentice …except it’s online 🙂
Trees Full of Money shows us how to deal with a situation where we’re ‘upside down’ on our car loan:
If you can no longer afford your “upside down” vehicle, here is a a better way to get out of your loan:
The most important step in unloading a vehicle with negative equity is to accept the situation for what it is. Saying “if I sell my vehicle now I’ll lose money” is not a plan. The quicker you sell your “upside down” vehicle, the less money you loose due to further depreciation.
The second step in selling an “upside down vehicle” is deciding on a fair market value. Lately, the value of used vehicles has been just as volatile as the stock market or the price of oil. The fair market value of your vehicle may be significantly more or less than used vehicle pricing guides such as NADA and Kelly Blue Book suggest.
Once you’ve established a competitive price, you need to secure funding for the difference between what you owe and what the vehicle will bring.
Once you have met the obligations of your loan, it’s time to do a little marketing and salesmanship. I little effort in the marketing of your vehicle can pay huge dividends.
When you have identified a prospective buyer for your vehicle, be sure to ask your bank how to proceed with the transaction. Each state has different laws so be sure to contact your state’s motor vehicle division as well.
[AJC: If you do want to sell your financed vehicle, I recommend that you read the full post here, as I have only extracted TFoM’s highlights]
But, where is Step 6??!!
It should be the one that says: how do I buy a replacement vehicle?
You see, unlike many things that you may choose to own, a car is probably a necessity … now, that doesn’t mean that you need the best car, but you do need a car that can achieve [Insert objective of choice: get to/from work; haul stuff around the farm; schlepp the kids; etc; etc].
So, what do you do?
Well, you first try as hard as you can NOT to get yourself into a financed vehicle in the first place …
… you see, almost anybody who has a financed vehicle is in a negative equity situation:
– As soon as you walk a new car off the lot it has depreciated 10% to 30%, yet you still owe 100% – deposit + payout costs on the loan,
– If your loan is longer than a year or two, the car is probably depreciating at a faster rate than you can pay down the loan.
If you’re not convinced that you are already ‘upside down’ on your loan, ask for a ‘payout figure’ from your finance company – this is the amount that they would expect in a check today to hand over the title to the vehicle to you ‘free and clear’ – and, get ready to choke! Go on, try it …
So, don’t get yourself into this predicament!
But, if that is the only way that you can get into your first set of wheels (is it really, truly the only way? Or, are you just kidding yourself?!), or you are already into a financed vehicle, don’t sweat it.
Just take a look at your current monthly payments and the payout cost … if you can payout the vehicle and buy a cheaper one with cash, go for it. But, the chances are you will need to hang onto your current vehicle, as long as you can afford the payments.
Now, if you can’t afford the payments and you ARE upside down on the loan (as you surely will be), you will need some help to negotiate your way into handing back the vehicle, walking away from the loan and finding a way to start again. Now, that’s a whole can of worms that you just don’t want to open …
… so, next time you’re thinking of upgrading your car with a nice little “low-interest dealer loan” … don’t 😉
We all have a car … otherwise, we’d be cycling to work. But how much car? Do you buy new/old or somewhere in-between? After all, our car is one of our largest purchases … if not, largest purchase outside of our own home.
So, here’s 7 case studies from our 7 Millionaires … In Training! ‘grand experiment’.
Let me know what you think …
Scott – like so many of the 7MITs featured here – loves his BMW’s … in fact, even AJC happens to have one, at the moment! The best thing, for Scott, is that his employer provided his current BMW for ‘free’ … but, is there really such a thing as a ‘free lunch’? We explore that very issue …
Ryan also likes BMW’s, which cause Josh to recommend buying a new one because it means NO “maintenance bill for 4 years, 50,000 miles” … is this a good deal?
Josh is obviously the other BMW-fan; we use his post to re-introduce the 5% Rule for cars and other possessions; should Josh have broken the rule to get int his first car? You might be surprised by the answer (it’s in the comments)!
Lee sure knows how to run a truck into the ground! Take a look at his attitude towards financing vehicles and how long you should hold on to your truck for …
Mark – the savvy investor – shows the other BMW-lovers how to buy a good used one off e-Bay and negotiate the price lower AFTER you have already ‘bought it’ … nice!
Diane and I have a discussion around what comes first, the “debt or the car”? It’s moot … Diane know what she needs to do!
Jeff has the cars the boat and the airplane (well, the airplane is supplied by the Navy!) … but, at what point is it better chartering a boat than owning one?!
… oh, and I finally come clean on my own car-related successes and failures, here