New or Used Cars 101 - Basics That People Get Wrong

Part 2/2 of Subscriber Request on Getting a Vehicle

This week we are going to wrap-up our mini-series on the finances around getting a vehicle. We have previously covered:

• An Introduction to How Car Leases Work in our free post, and

• An Analysis on Leasing vs Buying A Car Over the Long-Run for paid subs

Now we will look at buying new or used.

Should I Buy A New Or Used Car?

At first glance, this seems like a fairly straightforward question. Buying new is more expensive. Everyone knows that…efficienct markets and something something….when you drive the new car off the lot it immediately loses 20% of its value…no don’t ask how or why thats the case, it just is…Buying a new car is the devil…

Let’s cover some of the basics here and then later this week we will run the numbers with a real life test case. The results may shock you.

Watermelon has nothing to do with this…but I searched “results will shock you” in order to make fun of the cliche and this was the first image and, I hate to admit it, but I took a 15 minute detour to see what happens when you boil watermelon seeds. That line really does work…(and I guess you get a super healthy tea)

“A New Car Loses 20% Of Its Value As Soon As You Drive It Off The Lot!!!!!”

This is a personal pet peeve of mine, so I am putting it upfront.

It is one of those ‘kinda right but very wrong’ sayings that get repeated ad-nauseum. It sounds good & most people can’t explain why and if you think about it, it doesn’t make a lot of actual sense, but that just makes it catchy.

Usually it is some froogal acquaintance smugly saying it when you get a new car. Even worse if you took out a car loan to do it. Debt?!?!? How could you?!?!?.

“Why would you get a new car, you immediately lose 20% of the value!?!?”

-Smug froogal people

(Ironically, a lot of the froogal gooroos like to quote “price is what you pay, value is what you get” when talking about stocks, but can’t apply that same logic to car…almost like they are know-nothings just parroting things…)

First, why do you care what your resale value is in the first minute of owning the car?

Seriously, stop and ask that question. You aren’t driving it down the road and reselling it, right? If you are worried you may have to resell your new car hours to months after buying it, that is a red flag. You probably shouldn’t be buying a new car.

It’d be the equivalent of basing your engagement ring purchase on the value of smelted gold…probably not a good sign.

The value of the car you own is more than just the listed resale value. It includes the utility to you. If the car was worth >$50k to you when you bought it, just because you drove it off the lot and the market says it will pay you $40k, doesn’t mean the value to you is any less.

Second, there is a premium on a new car because its new, you get the stickers on the window and the show at the dealership. Not that this is a good reason, but there is a premium on new.

But third, and most important, is information asymmetry. If I am buying a brand new car I can be pretty certain nothing terrible was done to it. If you bought a car and owned it for a few months, days, or hours, I have no idea what you did.

You could have been driving it on the highway in 2nd gear. You could have tried a homemade NOS hook up before realizing you had no idea what you are doing.

Do kids still use NOS? I remember every child with a beat up Honda trying to get NOS in the car and racing on the local turnpike at 3 am. The amount of wrecked cars and blown engines was astounding…Thanks F&F

The point, when you are selling a car that you were driving, you have vastly more information about how the vehicle was used than the person buying. And because I don’t know if you were Vin-Dieseling it up in that car, I will want a larger discount to price than if it was just sitting at a dealership.

Lastly, new cars bought from the dealership tend to have the most and longest warranties and other perks. The added ‘peace of mind’ increases the cost.

A simple example to drive this home. Assume a car:

• Loses 60% of its value over the first 5 years

• Has a lifetime of 10 years total

• You can buy a new car today for $10k and drive it 10 yrs or

• You can buy a 5yr old car for $4k and drive it 5 years then buy another

In this simple example, the new car cost you an extra $2k over 10years and that is ignoring all the benefits of buying new that will decrease that gap.

Buying New or Used

When this question is asked, you need to consider the different types of used cars. There is very disparate costs and benefits to getting a car from some random person vs going to get a certified pre-owned vehicle from a dealership.

Also note - don’t take any of this as advocating to go buy a brand new luxury car you can’t afford. The question should be between new or used cars that fit easily within your budget.

Many Types Of Used Cars

Buying a used car can mean a wide range of things. You can go and buy a used car you find on Craigslist from some random or go to a big dealership and get a certified pre-owned (CPO) vehicle.

The price you pay and what you get will be very different from both. Buying in a private transaction should be the relatively lowest cost way to get a used car. You are trusting a random person who has no future obligations post sale. You buy it and you own it and any troubles that come along with it. (Although some states have lemon laws that may allow some limited recourse).

Also, most private sellers have little incentive to be truthful beyond the obvious. They aren’t in the car selling business and have little to no incentive to worry about a reputation.

Third-party dealers have slightly higher incentive to be forthcoming as they have a business reputation. Also, they likely have some limited services they can offer and maybe some warranty. Some even have their own ‘certification’ process on used cars.

As such buying a used car from a third-party used car dealer should likely fall in the middle price range, all else considered.

CPO are the fully vetted by the dealership and determined to be in above average operating condition vs peers. CPO vehicles were created to allow automakers to take advantage of low-mileage & excellent condition trade ins. Instead of sending the trade-ins to auctions, manufacturers could resell these cars with extended warranties and a few perks. Many CPO were leased cars, which means they had mileage restrictions and maintenance requirements.

However all those benefits of CPOs aren’t free.

You will pay up for a CPO, sometimes 10%+ more, for those added benefits and extra layer of dealership oversight.

Also, it is important to know what is a dealer program vs. automaker program. Some dealerships have programs that are only honored at that dealer.

Some car buyers want the CPO label. The thought is you pay more upfront to save on maintenance and issues down the line. But others point out that CPO is basically an extended warranty and not worth the price.

Advantages of Buying New Cars

• Easy

  • It is quickest to get a new car. You just find the car you want, find a good deal at a dealership or online, and you buy.

  • Less waiting for paperwork (like the title) post sale

• New Cars Have Deals

  • Cash-back, Extra trade-in value, or promotional financing are offered frequently on new cars

• Cheaper Financing

  • Even without a promotional APR, there tends to be a discount on the APR offered on new vs used cars. Since there is a lower chance of car issues and the borrower defaulting on the loan.

• No History

  • You don’t need to worry about what the prior owner did or didn’t do. You don’t have to worry about accidents or damage or issues that are covered up.

• All componenets are new

  • There is no wear & tear on any part of the car. This can be from normal driving (ie-brakes & belts) or from excess usage (ie-my kid sitting in my car playing with the seat adjusters for 20 mins everytime we come home)

• Full Automaker & Factory warranties

  • Typically get atleast 3 years bumper to bumper and 5-10 years on the powertrain for a new car.

• Can get exactly what you want

  • If you want a particular color, trim, or features, you can get the dealership to order the exact car you want.

• Technology/Safety/Gas Efficiency

  • New cars tend to have the most up-to-date technology, safety featurses and better miles per gallon

Disadvantages of Buying New Car

• Higher Price (Usually - current times are an anomoly)

• Higher insurance cost

  • If you have been driving an older car with a lower value, your insurance would be much lower than driving a brand new car

• More Tech

  • Yup, a pro and a con. Used to be you could open a hood and do minor fixes yourself. At a bare minimum, knowing a handy person was enough. The amount of computers in new cars makes it increasingly difficult to do home fixes and require going to a dealer where the price tends to be higher

• Have to buy at a dealership

  • Depending on where you live, this may severely limit your options and bargaining power

• High rate of Depreciation

  • Remember, for a constant depreciation rate, the value of your car decreases significantly more in the early months than later

Depreciation of car value over 12 years at a constant rate.

• Chance your loan is underwater

  • Since your car value may depreciate faster than the loan principal, there is a chance your insurance may not pay the full value of the loan if your car is totaled or stolen. In that case you would have to keep paying off the difference.

  • You could also pay for Gap insurance that will cover any gap between your loan and car value, but that is an additional monthly premium to a new car

Advantages to Buying Used Cars

• Price (usually)

• Lower insurance & taxes

  • Related to a lower price, the cost of insurance and tax you need to pay on the car will be lower.

• Rate of depreciation is lower the older the car is

• Lower chance of loan being underwater

  • Lower depreciation rates and smaller loans help to decrease this risk

• Any issues with a make and model will likely to have surfaced

  • Usually within a year or 2 of being on the road, any defaults in the manufacturing have come to the surface

Disadvantage of Buying A Used Car

• Buying someone elses old property

  • You will never know 100% what the prior owner did (see NOS example above)

  • Many people have ‘mechanic friends’ who can keep a car going but not really great, you don’t know what kind of issues were ‘fixed’ by bubblegum and duct tape

• Never know full history

  • Carfax and other services will tell you history when you give the VIN and pay the fee. This is a huge improvement vs not knowing, but even these reports don’t tell you not-reported accidents or how hard the owner drove the car

• Most likely sold as-is

  • Some states have short-term lemon laws (like 72 hours), but most used car & private sales are done as is. If a major issue occurs, you own the fix.

• Expensive APR on financing

  • If you are going through a bank for a used car loan, you will likely pay a higher APR than getting a new car loan.

• Lack of choices

  • You are at the mercy of the resale market. Which means you likely need to wait a long time and be very watchful if you are picky about what you drive.

• CPO are priced higher than other used cars, but likely offer the best APR, protections, and options

Wrap-up: Buying New vs Used Car

The car market is still highly fragmented and each region/dealer/etc may have great deals.

[‘Tism Note - F’er may know of some car savvy people who will go to cheap states and areas with lots of dealerships and buy cars to tow back and sell at a profit locally. There is certainly inefficiencies in the car market.]

In the next post we will look at an actual real-life example with cars available today to talk through some of the various options and see what the price differences is.

Remember, the actual results may shock you

(Also if anyone tries watermelon seed tea, let us know how it is in the comments)