A love affair that has lasted over 100 years!
(see more in the AUTO Slide Show)

The #1 consumer debt item that cripples most American households is the automobile.  How much car can you really afford?  Should you buy a used car, a new car, a new luxury car/sports car or just bum a ride everywhere you go? Should you pay cash, finance it with a minimum down payment, or just lease it?

VIDEO
Stretching Auto Loans to 6, 7, 8 years - (2 min 54 sec)
CNBC

Number of “Upside-Down” Vehicle Buyers Increasing
J.D. Power, Power Information Network - 3/25/04
(Notice the date on this article when you view the stats. Then listen to the video)

WESTLAKE VILLAGE, Calif.—The number of new-vehicle buyers who owe more on their trade than it is worth—the classic “upside-down” scenario—has increased substantially over the past three years, according to retail transaction data from the Power Information Network (PIN), LLC, an affiliate of J.D. Power and Associates. 

While only 25 percent of trades were an upside-down situation in 2001, today, 38 percent of trades are in this category, according to PIN.

This trend toward more upside-down trades is one of the consequences of the intense competition in the U.S. new-vehicle market.  To maintain share, manufacturers are keeping monthly payments of new or refreshed models the same by lengthening the terms of finance loans. 

The average length of a new-vehicle loan is now 58 months—an increase of almost 10 percent from three years ago when loans averaged 53 months.  Thus, retail consumers today who opt for the longer-length loans take significantly longer to build equity in their vehicle.

“If this trend continues, eventually the factory will have to provide a heck of a lot of assistance, which is not good news for the automakers,” said Tom Libby, director of industry analysis at PIN.  “Right now automakers are legitimately trying to sustain demand and market share through aggressive manipulation of finance instruments, but the long-term ramifications of these efforts are questionable.”

FAQs

• How much car can you really afford?

• Should you pay cash or finance your next auto?

• What about leasing it?

• Where do auto dealerships make their money?

• How much car can you really afford?

The best way to answer this question is to take a look at your budget.  What?  You mean you don't have a budget?  Well, I guess you need to flip over to the budget section if you don't have a monthly budget.  The rule you will learn in the budget section is that the combined percentages of your Net Spendable Income (more commonly known as "take-home" pay) for HOUSE, FOOD and AUTO should not exceed 65%. If you live in a cracker box and your definition of fine dining is an evening out at Taco Bell, then you might be able to convince yourself that you can afford to drive a relatively expensive auto.  My only warning is that you might never get out of that cracker box.

As a side note, I should also remind you that your monthly car payment is not a part of your AUTO expenses.  The monthly car payment (if you have one) should be listed separately on your debt repayment plan.  The AUTO category includes operating expenses only, things like gas, oil, maintenance, insurance, etc.

In order to decide how much car you can really afford, you need to start thinking of purchase price rather than monthly payments.  You need to look at your current financial situation and your goals for the future.  Do you own a home or are you working on saving the down payment for your first home.  Which is more important to you?  A down payment for a home that will appreciate in value or a shiny new auto that will eventually find its way to the nearest salvage yard.  It becomes a matter of priorities.

The emotional love affair that Americans have with the automobile makes it extremely difficult to make a logical decision when searching for their next vehicle.  I have seen couples on relatively modest incomes with excessive consumer debt justify buying or leasing a brand new luxury auto because they wanted something safe and reliable.  Remember that I said , "THERE IS NOTHING WRONG WITH BUYING A BRAND NEW EXPENSIVE LUXURY CAR AS LONG AS YOU CAN AFFORD IT!"  However, even if you can afford it, a one to three year old luxury car would be a better value when you consider the front end depreciation on new autos.

• Should you pay cash or finance your next auto?

There are several things that you should consider before deciding whether to pay cash or borrow the money when you purchase your next auto.  First, there is the fact that an automobile is a disposable item.  Everyday it becomes worth less and less until its only value is that of salvage.  This is called depreciation.  When you graph the depreciation curve of an automobile, you will notice that it is not linear.  

In other words, it does not depreciate in value an equal amount each year.  Most of the depreciation occurs during the first few years of the cars life.  According to consumer reports, a new car will depreciate approximately 40-60% within the first 4 years.  For example, even with a car that has a relatively strong resale value, the results are still sobering.  A 2001 Honda Accord has a MSRP of $25,500 while a 1997 Honda Accord would sell for approximately $13,000 or approximately 50% of the original sticker price.  The rapid depreciation of new automobiles far exceeds the amortization period of normal auto loans of four and five years.  When you finance an item that decreases in value faster than the loan is repaid, you no longer have the collateral to repay the loan in the event you become unable to make the payments (unexpected job loss, etc.).  This puts you in a position of "surety" (Proverb 22:26).  This is also referred to as being "upside down" in the loan.  Therefore, if you must finance your next auto purchase, do it in a way that will allow you to repay the loan faster than the value of the auto depreciates.  This can be accomplished by getting a short term on the loan (1-2 years).  Of course, if the auto you purchase is used, the depreciation will be at a slower rate.  However, many lending institutions are not always as generous when making loans for used cars as they are for new ones. 

It is a common occurrence that the need for a replacement vehicle occurs before the money required to purchase it is available.  The result is that you are forced to borrow the money to purchase the auto due to being unprepared.  The problems start when you go shopping for an auto with a "payment mentality" rather than a "purchase price" mentality.  This usually will result in the purchase or lease of a vehicle that is outside of your logical financial ability.  In the years that follow, as the car gets older and requires maintenance, the owner will still be making payments.  Before long the emotional distress pushes the owner to consider another new replacement vehicle and the cycle starts over again.  It is compounded when the old vehicle is traded-in for less than its value.  This process continues to eat away at the financial health of even the most well-intended person.  This conditions you to believe that you will always have a car payment as long as you drive.  It doesn't have to be this way.

You need to get into the financial position that will allow you to make a car payment to yourself and stop being a slave to the bank.  To do this, you must start with less expensive cars and work your way up.

• What about leasing it?

Simply put, leasing is nothing more than another way to finance an auto.  The major difference is that at the end of the term you have NOTHING!  In effect you are renting your transportation. 

An auto lease is generally designed in such a way that the lease payments will cover the depreciation of the auto plus a profit.  I doubt there are any companies that would be willing to lease you an auto knowing that they were going to lose money.  With this in mind, according to consumer reports, a new $18,000 auto will depreciate approximately 60% within the first 4 years.  That would result in the value of the car dropping to $11,000 by the end of the 4th year or a depreciation of $7,000. If you leased the auto for 4 years, you can count on your lease payments being $146 per month just to cover the depreciation.  When you add all the extras (return fee, excessive wear, excess mileage, etc.) you can see that the cost to lease an auto will always cost you more in the long run.  Below is a visual example of the way a lease works.  When you lease, you pay for the amount of the car's value that you use. If a car depreciates by $7,000 (35% of $20,000) during the time you drive it, you pay this amount plus interest and fees. (picture by Scott Jacobs)

Leasing has become popular because it offers the opportunity to drive a newer or more expensive auto for lower monthly payments than would be required if  the same auto were purchased through traditional financing.  The lease is a masterfully thought out business program that preys on the emotions of the average American who is living beyond his/her means.  The wording found in the marketing plans are designed to make them sound like they are the right thing to do.  For example, "SMART BUY" or "SMART LEASE" are names given to some of the newest efforts of dealers to cash in on those who live and die with a payment mentality.  Check out "A Consumer Guide to Vehicle Leasing" and the article "Auto Leasing: Six dirty secrets" (PDF Format).

Below is an example of the difference in the cost of obtaining an auto using three different methods:  Cash, Traditional Finance, Smart Buy (lease).

NOTE: If you elected not to pay the final balloon payment on the Smart Buy lease plan, then you would be required to pay a $250 return fee in addition to any excessive wear charges and excess mileage charges over the allowed 15,000 miles per year (different mileage plans are available for an additional charge). Without including any excess charges the Smart Buy would cost $7,759 for 23 months which result in a per mile cost of 52 cents ($1,000 + $250 + [$283 x 23])/15,000.  Doesn't sound too smart to me!

• Where do auto dealerships make their money?

Auto dealerships have different means of earning a profit and you might be surprised when you see where they make their money. In an article published by Smart Money Magazine, it was reported that according to the National Auto Dealers Association, auto dealerships derive their profits in the following order:

1. Financing Contract (traditional or lease)

2. Shop Repairs

3. Extended Warranties

4. Sale of Auto

Note:  New Car Loans at Auto Finance Companies
Interest Rate - 5.87%
Maturity (months) - 56.4
Loan to Value Ratio - 90
Amount Financed - $23,065
Source: Federal Reserve Statistical Release on Consumer Credit, March 7, 2008
The above data would result in a payment of $472.78 per month.

As you consider the method that you are going to use to acquire your next auto, take time to understand the consequences of your choice. Put your emotions aside and make a wise decision based on your needs and financial abilities. 

Take a look at my AUTO project