Taking out a loan to buy an automobile is good debt. If you live in America’s suburban sprawl, you typically need a car to travel to work. Purchasing an automobile is a big event in most people’s lives, so try to get advice from a parent or friend who has experience in that area. An automobile is, in economist’s jargon, a durable good, a good that lasts over three years. The price to consider when purchasing a durable good is the user cost. The user cost of a car is the total monthly (or annual) cost of financing and operating the vehicle. Specifically, these are the costs you need to investigate:
- The annual finance payment
- The annual fuel cost
- The annual maintenance cost
- The annual insurance costs
- The annual replacement costs of tires, etc. (most important when a car is over 3 years old)
- The trade-in value
These costs can vary significantly among various makes and models of cars. The largest component of your user cost is the financing. Interest rates for automobile purchases will vary with the market interest rate and generally track the 5-year U.S. Treasury Bill, plus a risk premium. According to The Wall Street Journal, as of August 2021, the average rate on a 48-month new car loan nationwide was 4.06%. Based on this, we can determine the annual user cost of a $30,000 car:
Table 7.3. Annual User Cost of a $30,000 Car
Annual Finance Costs $8,148 ($679 per month)
Annual Insurance $1,134
Annual Fuel Costs $2,392 (16,000 miles/yr @ $3/ gallon)
First Year Maintenance $500 (Oil change and tire rotation)
TOTAL $12,174
The financing rate varies significantly with market interest rates, and often the auto manufacturer will give lower rates in order to sell specific models. Be sure to ask for a dealer quote on financing your car. You can use an auto loan calculator to figure out your monthly finance costs.
A common saying in the auto industry is that your new car is worth 25% less the minute you drive it off the dealer’s lot. In actuality, your car’s value decreases around 20% to 30% by the end of the first year. From years two to six, depreciation ranges from 15% to 18% per year, according to recent data from Kelley Blue Book, which tracks new and used-car pricing. As a rule of thumb, in five years, cars lose 60% or more of their initial value. However, this can vary widely among makes and models, so it is worthwhile to investigate to what extent your chosen vehicle keeps its value. Remember that you will never recoup the cost of premium customization you may buy on your new car. Special models, expensive wheels, or deluxe sound systems will not increase the trade-in value of your car. Essentially, this money you are throwing away.
Unfortunately, 2021 was a bad year to buy a new or used vehicle. As we exited the Pandemic Recession, the demand for new automobiles increased while at the same time, there were serious supply shortages of the computer chips that run everything in today’s sophisticated cars. In addition, the prices of used cars increased 40% over the year 2020. However, this inflation in auto prices should be temporary, so here are some ways to minimize your user cost when buying a car in years like 2021.
- Finance your purchase through a credit union. For example, I have seen rates between 1% and 2% on new auto loans at Pentagon Federal Credit Union.
- Finance your loan over 60 months in order to bring down your monthly payments.
- Do not load your car up with customizations.
- Buy a used car with a warranty instead of a new car.
You should first establish a monthly budget, keeping in mind the user costs. Then make a list of the few cars that will ft that budget. Drive the three cars that ft your budget and choose the one your gut tells you that you like the most. That way you will be happy with the purchase.
As an economist, I recommend leasing your car instead of purchasing it. Leasing is just another method of financing your car purchase, with a number of added benefits. Leasing significantly reduces your monthly payment, helping your cash flow. When you purchase a vehicle outright, you pay interest on the amount you borrow. You also have to pay off (or amortize) the entire cost of the vehicle over the term of the loan (typically 4 to 7 years). When you lease a vehicle, you pay interest on the amount you borrow, but you only have to amortize the difference between the purchase price and the vehicle’s residual value. Here is an example of a purchase vs. lease monthly payment:
Purchase
- Price: $32,000
- Loan: $30,000
- Interest rate: 4%
- Term: 48 months
- Monthly Payment: $677.00
Lease
- Price: $32,000
- Loan: $30,000
- Interest rate: 4%
- Term: 36 months (almost all leases are for 36 or 39 months)
- Monthly Payment: $535.00
When you purchase a car, you must pay sales tax up front. Not all states have sales taxes, but in Pennsylvania, for example, where the sales tax is 6%, this would be $1,920. For a lease, you only pay sales tax on the lease payment every month. You can purchase the car or truck at the end of the lease for the residual value, or you can just turn the vehicle in and lease another new vehicle.