Client Question: How Should I Pay For My New Car?
Occasionally a FORTIfi client will contact us to ask, “How should I pay for a new car? Should I take out a car loan, or should I get a personal loan, or should I add the cost to my mortgage?”
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It is not an easy question to answer – you’d think the best course of action would be to do whatever gives you the lowest interest rate. However, some calculation is required; a loan for 25 years at a low interest rate may be considerably more expensive than a loan for five years at a higher interest rate. In short, you need to calculate what is best for you. |
There is a more important question here:
Is it wise to borrow money to buy a car?
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But there is a more important question here;
Is it wise to borrow money to buy a car?
The answer is, not really. Check this out – the five common mistakes people make when taking out a car loan.
1] Choosing the wrong car.
What car is the wrong car? One you cannot afford!
Once you see a car you like and let the salesperson know you’d like to borrow the money to purchase it, you’ll be told how much the monthly repayments are on that car. The amount may sound reasonable and, having done some calcualtions, you may think you can afford that amount, but have you factored in the real cost of running the car? Did you include warrant, registration, petrol, insurance?
Some of those costs are fixed irrespective of the type or size of car. Others, such as petrol and insurance are not and they can push up the cost of running your car.
The lesson is simple. Before you go car hunting, calculate how much you can afford to pay, per month, on vehicle expenses. Then, subtract the cost of
• petrol, • insurance, • registration, • warrant of fitness • and maintenance.
This leaves you with the amount you can afford in loan repayments (don’t forget there will also be a cost for setting up the loan). Stick to what you can comfortably afford.
2] Buying new when used will do.
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We’d all love to drive a brand new car. There are no rattles or shakes, it drives smoothly, it even smells good! But here is the reality; in the first two years of ownership a new car loses approximately 30 - 40% of its value. If money is of no concern to you, then perhaps you can afford a brand new car. For most people, however, it makes more sense to buy second-hand. Don’t forget, second hand can be only two or three years old - new enough to look modern and have many of the latest features without the immediate depreciation. |
In the first two years of ownership a new car loses approximately 30 - 40% of its value.
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3] Not working out how much the deal is going to cost.
When we are in a car-yard focused on buying a vehicle and a monthly repayment is mentioned, it’s very easy to get carried away. Before you sign anything work out exactly how much the deal will cost you and just what you are getting for that deal.
Consider this deal;
• You see a car worth $7,000 and decide to take out a loan to purchase it.
• The Interest rate = 13.5%
• The loan is to be repaid over 4 years
• You will pay $189.53 a month
• EXCEPT that there will usually be a loan set-up cost. Typically this will be about $250.
• Add that on and your repayments are now $196.30 per month (the $250 set up cost pushes the cost up because if you add the $250 to the loan it becomes part of the loan and so, you will repay that cost over four years at 13.5% interest.).
So:
• After four years you will have paid $9,422.56 for the car
• This includes $2,172.56 in interest.
• And you haven’t paid for any on-road costs. And, if the car is new to New Zealand it may require registration etc.
So, over four years, not only have you given away over $525 each year in interest, the vehicle has also dropped in value. This is why vehicle finance usually only runs for four years. It’s because the security the lender has over the loan is the car itself. And, because that security is decreasing in value, the lender knows they cannot stretch the loan out too long without the risk of losing money should the loan not be able to be repaid.
Now:
• if you put $196.30 a month into a bank account instead of a car loan, you would save $7000 in a little under three years. (make sure you read the case study at the end of this article).
Anyway you look at it, buying a car using a deal like this is not a great financial practice. Better to buy a cheap car while saving for the one you’d really like.
4] Making the length of the loan too long.
It is easy to look at the repayments on a loan and conclude that the longer it runs for the cheaper it is. This is not so. The repayments may be more manageable on a month by month basis, but in the long-term it can cost a lot more money.
Let’s go back to our example above. If the loan was only for 24 months and not 48 months;
• A car valued at $7000
• Plus $250 set-up costs
• Interest rate 13.5%
• This time payable over 2 years (rather than 4)
• You will pay $346.38 per month – that is about $150 more per month but...
• After two years you will have paid $8,313.20 for the car (not $9,422)
• Which includes only $1,063.20 in interest.
• A saving of 1,109.36!
Now, we know those monthly repayments of $346 would be beyond most people, but it does show how money can be saved by shortening the payment periods of a loan if it’s at all possible. Many financial advisers would say that a person should limit their car loan (if they choose to have one at all) to what they can afford to pay off in a maximum of two years.
5] Owing more than the car is worth.
Sometimes this is called, “getting upside down in your loan,” and it can happen very easily. A long term loan, coupled with a vehicle’s quick depreciation, can mean that there comes a point where you may owe more than the car is worth. That is heartbreaking, especially when you decide to sell the car and find that you still owe money on something you no longer own. This is not an uncommon scenario - it happens to many people.
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Case Study: |
Bob and John each want to purchase a car.
Bob has a $1,000 deposit and decides to borrow the rest of the money he requires.
He borrows $10,000 spread over five years.
His payments are about $300 a month.
It costs him about $130 more per month to run the car than it would cost to use the bus to get to work and around town.
That means Bob is paying $430 a month for his car. Over five years that equates to $25,800.
At the end of those five years he owns his car outright but the $11,000 value has now dropped to around $5,500 and he has no savings. This means, if he wants to update his car he will need to borrow money again.
John decides to acquire a car a different way. He decides to save for it. He puts aside $300 a month and, after five years, has saved over $30,000. With this amount of money he can afford a near new car.
At this point he continues to save money because, first he has no debt to repay. And, second, his near new car has lower running costs.
After a further five years, Bob is preparing to borrow money to purchase his third car. John has a car that has a good resale value and, coupled with his savings, enables him to buy another near-new car for cash.
Sure, John had to delay his until he’d saved the cash, but he is on a pathway of purchasing and driving a newer car. Bob is condemned to driving an older car unless he can find a way of saving while still making loan repayments. |
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The bottom-line is this,
you should avoid borrowing money for ALL assets that depreciate – that is, that decrease in value.
Such items are best saved for and purchased with cash.
To read our Resource Centre article A Word about Extended Warranties, click here.
