People, especially the Hordes of consumers out there, love shiny new things. They say things like ‘ooohhh’ and ‘aaahhh’ when they get a new item. They’ll even pay extra to get something new, safe in knowledge that they are the first to use it.
It’s rarely worth it though, paying the premium to get something new.
New items lose value at the fastest rate. As soon as they have been purchased, they are no longer ‘new’ and they lose that ‘new premium’. Nothing has changed about the item, it still smells the same, it is just no longer ‘new’.
It’s value is said to have depreciated. Depreciation being the reduction in value over time.
Certain assets can appreciate. Shares in a company. Real Estate. Vintage cars. Commodities.
Others depreciate. Designer t-shirts. Diamanté encrusted handbags. Mobile phones. Novelty mugs.
And, of course, auto-mobiles. Auto-mobiles are particularly interesting for the casual finance warrior, like yourself, as they represent a potentially significant purchase. Not only that, they represent a chance to get caught up in the buying-more-shit-than-you-need mania that infects the majority of fools out there. There’s nothing that says ‘I’m worth it‘, like an excessive car.
A car purchase represents a chunk of capital that could otherwise be tirelessly working for you, for example earning interest in a savings account or growing through capital appreciation and dividends as shares in a company.
Imagine you have £30,000 in capital. It is sitting there, just brimming with potential. As you sit, cross-legged in your living room staring at the pile of cash, you begin to day dream. You could invest that in a diversified basket of shares, for example in the Vanguard All World ETF ‘VWRL’, which might grow at 7% a year. Or buy a brand new car with it. An Audi A3 with a few optional extras, like this.
Finding an accurate car depreciation formula is near impossible. Finding information on estimated car depreciation rates is also near impossible. For brevity I have used a flat rate of 20% for depreciation, it leaves us with total depreciation of around 50% after three years, which seems to be in line with common thoughts about car depreciation.
The car depreciation formula I’m going to use is simple;
Car Value = P(1-r)^t
Where P = purchase price of the car, r = depreciation rate and t = the number of years from the purchase date.
Let’s have a quick look at these two scenarios and how they might pan out over 10 years. £30k for a vehicle purchase depreciating at 20% per year or invested and earning 7% a year;
The projections are starkly different, admittedly it’s using simple investment returns and car depreciation formulas, but it’s a start. The car ends up with a residual value of about £3k. The investments grow to just under £60k. That’s a mighty large difference.
The point here isn’t don’t get a car, it’s realise how much depreciation alone could cost you. Look at the car depreciation formula again. Depreciation is a function of the purchase price of the car, i.e. depreciation is a larger cost for a more expensive car.
In this example there is an effective spread between the depreciation rate and investment return of 27%. ‘Spending’ the £30k in these different ways results in a £56k wealth differential in 10 years time. You better be pretty certain you;
- need a car, and
- need to spend that much on a car.
The Finance Zombie doesn’t drive to work or to the shops. That’s what his feet and bike are for. In truth, when I initially engineered my job to be close to home it was nothing to do with saving money. It was purely to do with saving my time from doing something as stressful and unhealthy as commuting in a car. Saving money has since become a lovely side benefit to this lifestyle.
What about if you were so desperate to get a new car, you took out finance to achieve this dream. And then rolled over the car into a new one (and a new loan) after 5 years?
I can hear you grinding your teeth, crushing water melons with your bare hands and judo chopping bricks in half with fury at this. Please, bear with me while we step through this ludicrous example.
In one scenario you borrow the £30k to buy your dream machine, over 5 years at an interest rate of 4%. The monthly payment works out at £551 a month. Hey, you’ve got a promotion and you deserve to drive something nice after all.
After the 5 years, you sell the car for it’s depreciated market value and take out another loan for the difference to get your next £30k car and pay this off over the next 5 years.
In another scenario you like the cut of Mr Z’s jib and engineer your life so work is walking distance from home and invest the £551 each and every month in a diversified cauldron of investments. It returns 7% a year for the next 10 years.
Remember, we’re only looking at the cost of depreciation here. Nothing else. Not the cost of fuel, maintenance, insurance etc.
So, how does it look?
In monetary terms, investing the monthly amount obviously turns out better.
At the end of the 10 years old Vehicly McVehicleFace ends up with a car worth just under £10k and nearly £11k in cash. I assumed the individual would take out a smaller loan for the second car, after using the proceeds from the sale of the first. This would result in lower monthly payments. The difference between that at the first loan would be invested in cash. Let’s give them the benefit of the doubt and assume they wouldn’t use the proceeds to just buy a more expensive car.
Where as old Investy McLegendFace, the individual investing the £551 a month, would end up with nearly £95k.
That’s a £74k difference after 10 years. Bugger a plant pot, we are only looking at the goddam cost of depreciation and financing the arsey thing and there is a £74k difference. (That deserved a peppering of swearing to soften the blow).
Let’s break it down a little. The Investor is earning a positive 7% on their money, this asset is appreciating. The Borrower has borrowed money, on which they are paying 4% interest. In addition to this, the asset that they purchased with borrowed funds is actually decreasing in value.
The Borrower has used a source of credit to make an item that decreases in value even more expensive to buy!
Mr Zombie does own a car. I know, the arrogance, after this mini-rant. But in his defence it is 16 years old and cost £2k about 7 years ago.
I’m happy with an asset worth £2k depreciating, the cost is worth the benefit. I couldn’t have driven an hour away from my house for a hike this weekend, for example. And the lost investment returns aren’t going to be anywhere near the £74k difference we saw above.
For others, a car might be necessary for their career or lifestyle, and that’s cool. But it becomes uncool when the car starts to cost more than their annual salary and they complain it’s tough to get anywhere in life.
So no, I’m not against auto mobiles in general, they are utterly fantastic bits of precision engineering that make our lives far easier. Yet it does sadden me to see an automobile being used as a badge of wealth or a status symbol. How someone can think that an item that they simply bought makes them better than someone else is beyond me.
Incidentally, I do also see the attraction of the more expensive side of cars. I’ve been for rides in Audi’s, Porshce’s or Lotus’ (that was a short lived idiotic purchase) and they are without a doubt more luxurious or quicker than my humble Seat Ibiza. Yet, for the majority of us, they simply aren’t worth the outlay of capital. It represents too large a portion of our wealth or income that it just doesn’t make sense.
Financial Samurai’s 10% rule does a good job at trying to rationalise how much you should spend on a car. It’s based on 10% of your income and so makes an attempt at stopping you purchasing ‘too much’ car, which is only good in my opinion.
An appreciation (teehee) of the true cost of both depreciation and the loss of investment returns should be garnered before laying out a chunk of capital, on what is a motorised throne of laziness and muscle atrophy.
Depreciation isn’t limited to auto-mobiles, it impacts most consumable assets. Electronics and tech items suffer from it heavily, with many becoming obsolete after a few short years. But it is on automobiles that depreciation is in it’s most visible and significant form for most of us.
Remember, depreciation can be depressing. So buy a car you can actually afford and depress the cost of depreciation to you.
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