Cost-effective to buy a new car?

[Sam_Stone]

@Small British Shop Owner

It is true, and there is a very famous (and accessible) paper written about it. See Wikipedia @ The Market for Lemons - Wikipedia

Everyone should read this. Information asymmetry is a critical problem in the used car market. From the article:

as quality is undistinguishable beforehand by the buyer (due to the asymmetry of information), incentives exist for the seller to pass off a low-quality good as a higher-quality one.

The buyer, however, takes this incentive into consideration, and takes the quality of the good to be uncertain. Only the average quality of the good will be considered, which in turn will have the side effect that goods that are above average in terms of quality will be driven out of the market. This mechanism is repeated until a no-trade equilibrium is reached.

As a consequence of the mechanism described in this paper, markets may fail to exist altogether in certain situations involving quality uncertainty. Examples include the market for used cars, the dearth of formal credit markets in developing countries and the unavailability of health insurance for the elderly (that is, in the absence of government programs such as Medicare).

However, not all players in a given market will follow the same rules or have the same aptitude of assessing quality. So there will always be a distinct advantage for some vendors to offer low-quality goods to the less-informed segment of a market that, on the whole, appears to be of reasonable quality and have reasonable guarantees of certainty. This is part of the basis for the idiom, buyer beware.

So let’s go over this again: Let’s say you’re selling a used car. You know it’s of above-average reliability, but you just want something newer. So if an average car sold for $10,000, you’d value yours at $12,000, and that’s what you want to sell it for. If someone offers you $10,000, you won’t take it.

Now, let’s say you have a lemon. You try to pass it off as average and sell it for $10,000. But to you, it’s only worth $8,000 because of problems you know about but the buyer can’t discern.

Now let’s assume the buyer is only willing to pay the average price - he doesn’t know whether your car is a jewel or a lemon. So what happens? The good car can’t find its asking price, and drops out of the market. The only vehicle available to you is the lemon.

Now that this takes place for a while in the marketplace, it becomes known that used cars that are privately sold are more likely to be lemons than not. Now the buyers discount the price even more, driving the next-best vehicles out of the market. Eventually, you wind up with a market of nothing but lemons, selling for lemon prices.

How can you avoid this? There are several ways: One is to have the vehicle inspected, but this will only reduce some of the uncertainty. Another is to buy from a reputable dealer with an incentive to maintain a reputation. Here’s what happens: When dealers take in trades or lease returns, they inspect them thoroughly. If the vehicles are above-average in quality, they keep them and sell them as used vehicles. This enhances their reputation, and allows them to charge more for the used vehicles, increasing their profit.

If the vehicles they take in trade or on lease return are below average, they’ll send them out for auction. Some of these are purchased by private individuals who are willing to trade the lower price for the risk of reliability issues. Many of them are bought by agents of lesser car dealerships, or by ‘curbers’ - shady individuals or small companies who look for cheap flawed vehicles, cover up the flaws, and resell them as better than they are.

The result of this information asymmetry means that ‘Cars for Cash’ on the corner is likely to have a lot full of overpriced lemons, no matter how low the window sticker price seems to be. They have no reputation to protect, and they stay in business by appealing to the desperate and ill-informed. A BMW dealership in a 2 million dollar building is unlikely to intentionally sell you a lemon - but there will be a premium on their used cars as their price for assuring quality for you.

Now, you can find great deals sometimes if you’re willing to look at private sales and do lots of work inspecting the vehicle, examining its service history, etc. But when buying an older vehicle, remember one thing: The person selling it is probably doing so because he’s finding it increasingly unreliable and expensive to operate.

This is why I advocate buying a 2 or 3-year old lease return or car that someone traded in for a new model. Now you’re in the area of the market flooded with cars that were returned for no reason other than that the lease expired or the seller likes to drive new cars. so the percentage of lemons should be about average. You have a warranty which protects you from hidden defects for a couple more years. And you avoid the bulk of the new-car depreciation.

To me, that’s truly the sweet spot for car value.

[Sam_Stone]

@Lunar Saltlick

Is this always true, though? We bought a new Honda Civic hatchback in 2000, and we looked at used models that were two or three years old, and, frankly, there wasn’t a huge difference in price. Used Hondas that were 12 to 36 months old were in such high demand they only stayed on the lot for an afternoon at best. I think you’re generally correct with many makes of car, but there are some makes out there that defy generalization.

That’s why I expressed a range of 30-60% - really a very large difference. The best cars will have depreciations at the low end, and the worst cars at the high end.

For example, according to this cite, this is how a Honda Civic will depreciate in value:

2006 Honda Civic price range: $10,075 - $21,875
2005 Honda Civic price range: $7,275 - $19,175
2004 Honda Civic price range: $6,450 - $17,225
2003 Honda Civic price range: $4,250 - $16,150

Note that at the bottom end, a Honda civic loses about 35% of its value after three years, and almost 60% of its value after four years. At the high end, it’s not so bad. After four years, the civic is still holding more than 60% of its value.

@Dewey Finn

I bought a two-year-old Honda Accord eleven years ago. After buying it, I looked at the prices of new Hondas and figured that I saved very little by buying the car new, since Accords hold their value so well. It seems to me that if you buy a car brand-new, you get the full warranty and if you hold it until it dies years later, who cares whether it depreciates?

Let’s look at it this way: Let’s say you buy that bottom-end Honda civic new, and drive it for ten years, at which point it’s worth essentially zero. Cost per year: $1, 075.00. Now let’s say you buy one that’s four years old, and drive it for six years. Cost per year: $708. In the end, you have a car that’s ten years old either way. But by starting used, you’re saving more than 30% per year.

Let’s make it worse: Let’s say you financed the vehicle for five years at 7%, with $1000 down on both. In the first case, you will pay $1706 in interest. In the second case, you will pay $611 in interest. Now the new car cost you $1100 more over those ten years.

To make it even worse, the insurance on the new car will be more expensive, and you will have to maintain it to the manufacturers service schedule at your cost or risk losing your warranty. And since the manufacturers have an incentive to be conservative with servicing (since you pay the cost of service, but they pay the cost of warranty damage), you’ll pay more for service, too.

[DrDeth]

@Sam Stone

2006 Honda Civic price range: $10,075 - $21,875
2005 Honda Civic price range: $7,275 - $19,175
2004 Honda Civic price range: $6,450 - $17,225
2003 Honda Civic price range: $4,250 - $16,150

Note that at the bottom end, a Honda civic loses about
Let’s make it worse: Let’s say you financed the vehicle for five years at 7%, with $1000 down on both. In the first case, you will pay $1706 in interest. In the second case, you will pay $611 in interest. Now the new car cost you $1100 more over those ten years…

BUT- Civics are getting bigger and with more features over the years. So comparing a 2003 Civic to a 2006 Civic and you aren’t comparing the same car.

And, on a really late model used car, the dealer will sometimes offer those “way below prime” interest rates. A Honda dealer offered me 1.9% on a less than a year old Acura. Along with an extended warrenty.

[Sam_Stone]

@DrDeth

BUT- Civics are getting bigger and with more features over the years. So comparing a 2003 Civic to a 2006 Civic and you aren’t comparing the same car.

You can do the same calculations for other vehicles that are essentially the same. For example, a 2005 Ford Escape is virtually identical to a 2001 model. If you parked them side by side, you’d have to be an enthusiast to tell which one was the newer one. The black book value of a 2005 Ford Escape XLT V6 is $20,100. A 2001 Ford Escape Limited is 10,225. That vehicle lost half of its value in four years. If you find a low-mileage 2001 in good condition, it will be significantly cheaper to own over the next five years than if you bought new.

And, on a really late model used car, the dealer will sometimes offer those “way below prime” interest rates. A Honda dealer offered me 1.9% on a less than a year old Acura. Along with an extended warrenty.

Sure. Every situation is different. As I said in my first message, I bought a new car last time precisely because the factory rebate and financing incentives actually made it cheaper to own than an equivalent 2 year old vehicle. So you need to do your homework. But in general, buying new always costs a premium over buying used. It’s simply a more expensive way to own a car.

[Giraffe]

@Incubus

My current car runs okay, but it has 97,000 miles on it and if it died on me today I wouldn’t have the money to replace it. I feel like having a new car (with a warranty) would give me more long-term reliability, since planned expenses seem less expensive than unplanned expenses.

From a purely financial standpoint, by far the most cost effective thing you can do is drive your paid-off car into the ground and stick the car payment into a savings account. Every month you drive that car, you’re making $300-$400. When it breaks down and costs more than a couple of hundred bucks to fix, that’s when you junk it and go buy a new one. If you’re lucky, this will take a few years and you’ll have saved yourself thousands of dollars by then. The trick, of course, is to force yourself to save that money and not just spend it on something else. (I recommend automatic withdrawals into a savings account every payday.)

If you want a new car simply because you want something new and shiny, go ahead and buy it, but do it with your eyes open. (And by new car, I mean new to you – the new vs. used decision is all about the model, the price and the financing.)

The biggest financial mistake most people make is increasing their lifestyle along with an increase in their salary. If you can make yourself live on (e.g.) $25k/year and save the difference, you’ll have more and more money, as you go from paying interest to earning it.

[Lunar_Saltlick]

@Sam Stone

… But in general, buying new always costs a premium over buying used. It’s simply a more expensive way to own a car.

I guess you’re convincing me, but I still maintain (albeit based on my anecdotal evidence and not your stats) that with the Civic, that premium is smaller than with most makes and isn’t tough to swallow, especially since I know the car is brand new, and it has exactly the color, trim and options that I want. I also don’t have to search and wait (as I said, in my area, used Civics disappear as soon as they’re listed). I’ll also freely admit that I’m not at all a car guy; I have no intention of trying to figure out whether a 36-month old car has been well-maintained, etc. I know there are inspectors for that, but my experience with inspectors has never been great.

In the end, you’re right – all things being equal, buying used is cheaper. But all things are never equal. With a new Civic, the premium isn’t huge, I get exactly what I want, I don’t have to wait, I don’t have to wonder about the inspector, and I don’t have to know any more than necessary about the car, something I see strictly as a means of going from A to B. I realize that attitude sounds sad-ass pathetic to many people, but there it is. When it comes to cars, I’m willing to pay extra for the convenience.

[Hello_Again]

Normally, I would say that a 1-4 year old used car is a good value if you have a trusted independent mechanic to inspect it.

However, some of the Korean car manufacturers are offering some pretty amazing warranties to the first buyer only.
For example Hyundai’s first-owner warranty includes: 10yr/100K on powertrain + 5yr/50K bumper to bumper + 8yr emissions + some other stuff
The second buyer gets 5yrs/50K starting when the first buyer bought it. Theoretically, you should have it completely paid off by the time the bumper-to-bumper expires, and still be shielded against a transmission/engine problem for another 5 years.

So, if having a comprehensive warranty is important to you, there is some advantage in buying a new, inexpensive Korean make. I have a Hyundai Accent GS hatchback, its a cheap getabout with great milage and has been very reliable, easy to park and inexpensive to insure. I paid $5k when my 2002 was 4yrs old. New, the Accent GS hatchback starts at $10,500.

[Sam_Stone]

@Lunar Saltlick

I guess you’re convincing me, but I still maintain (albeit based on my anecdotal evidence and not your stats) that with the Civic, that premium is smaller than with most makes and isn’t tough to swallow, especially since I know the car is brand new, and it has exactly the color, trim and options that I want. I also don’t have to search and wait (as I said, in my area, used Civics disappear as soon as they’re listed). I’ll also freely admit that I’m not at all a car guy; I have no intention of trying to figure out whether a 36-month old car has been well-maintained, etc. I know there are inspectors for that, but my experience with inspectors has never been great.

Hondas hold their resale value better than most cars, because they are built so well. So that means the premium for buying new isn’t as high (your gut instinct is right). But it also means that there’s less risk in buying used, because the cars are so well built that 2 years of use won’t affect the car as much (which is why they hold their resale value, of course).

I guess this just means that the decision is closer with respect to buying used or new, so other factors are more in play.

If I were you, I’d probably buy new as well. I’m willing to pay a modest premium for knowing I’m the first owner of the car and that nothing crazy was done to it. I just won’t pay a fortune for the privilege.