As a Fool.com reader of some distinction, you likely already know that buying a used car is a better financial decision than buying a new one. Today, I'll explain how much better it can be.
We'll begin our analysis by imagining a man standing at the entrance to a car dealership with $6,000 in his pocket. He will enter the dealership on foot but will drive out in a car. We'll consider two possible scenarios: He decides to be Mr. Thrifty and chooses a used car, or he decides to be Mr. Extravagant and goes with a new one.
Mr. Thrifty buys a used car that he can afford with the cash in his pocket: $6,000. He has the following expenses in his first year of ownership:
- Loan repayment: N/A
- Insurance: $70/month
- Fuel: $65/month
- Maintenance: $300/year, paid at end of year
Mr. Extravagant buys a new car for $12,000. He puts $6,000 down, but to afford the rest, he takes out a $6,000 loan that matures over five years at 4.5%. His expenses in the first year of ownership are:
- Loan repayment: $111.20/month
- Insurance: $140/month
- Fuel: $45/month (new car is more fuel-efficient)
- Maintenance: $0/year (new car has a maintenance plan)
For both buyers, all expenses increase at 2.8% annually except the loan repayment, which is fixed.
Mr. Thrifty and Mr. Extravagant's first-year expenses are $1,920 and $3,554, respectively. Mr. Thrifty uses the $1,634 he saves in the first year to invest on a monthly basis, and he continues to save for the next five years of ownership (see graph below). Meanwhile, by the end of year five, Mr. Extravagant has repaid his loan and owns his car free of debt.
Each car depreciates in value at 10% per year, meaning that by the end of our five-year period, Mr. Thrifty's car is worth $3,543 and Mr. Extravagant's is worth $7,086. Mr. Thrifty's investments earn 10% per year, compounded monthly, while Mr. Extravagant has no investments. The graph below compares their net worth at the end of each year.
By the end of the first year, Mr. Thrifty has saved a total of $1,634, which has grown in value to $1,722. Meanwhile, his car has lost 10% of its value and is worth $5,400. His total wealth is $7,122. Mr. Extravagant's car has lost 10% of its value, so it's worth $10,800 at the end of year 1. Meanwhile, he still owes $4,903 on his loan. His total wealth is therefore $5,897. The same story plays out four more times, with expenses adjusted for inflation. By the end of five years, Mr. Thrifty has a car worth $3,543 and an investment portfolio worth $10,614, for a total of $14,157. Mr. Extravagant has finally paid off his loan and has a car worth $7,086. Mr. Thrifty is twice as wealthy as Mr. Extravagant.
Drive the right path
The main thing Mr. Extravagant did wrong was using an interest-bearing loan to buy a depreciating asset; in doing this, he lost money in two ways. The main thing Mr. Thrifty did right was saving the money he didn't spend on a new car. This is important: If Mr. Thrifty had not saved and invested that money, he'd have ended up less wealthy than Mr. Extravagant at the end of five years ($3,543 versus $7,086), and he'd have spent all that time getting less respect from his peeps. On the other hand, if Mr. Thrifty's friends are the type of people who judge others based on their car, perhaps he could do with better friends!