LISTEN: Your Next Car: Buy Or Lease, New or Used (mp3audio) (7:54 min)

For most Americans, personal transportation is a necessity. This makes financial planning to buy a car a necessity. They need a car to work, to get the groceries, to drop the kids at school, and to access entertainment. This means most Americans will face a significant financial transaction every three to five years when it becomes necessary to replace a vehicle. Each time, the two biggest financial questions are:

1. Should I buy or lease the vehicle?
2. Should I buy a new or used vehicle?

While some financial experts may hold to hard-and-fast answers to both questions (comment from one financial website: “never, ever buy a new car!”), other information suggests that the “right” decision is dependent on a number of constantly changing market factors, as well as your own priorities regarding automobiles.

Your car: A monthly expense or a capital investment?

There are two ways to evaluate the purchase of a vehicle. One is to consider a car as part of one’s monthly transportation costs, the other is to see an automobile as a piece of equipment with capital value. The transportation cost model includes fuel, garage or parking space fees, repairs and maintenance, insurance, licenses, tolls, as well as monthly payments on a lease or loan. The total of these expenses represent your transportation costs, and the relevant financial issue is the size of this number. Any discussion of the residual value of the vehicle after three to five years is inconsequential; the main concern in having reliable transportation and keeping the costs affordable.

In contrast, when the vehicle is considered as a separate capital investment, a new set of metrics apply. There is a projection of how long the vehicle can be driven before its transportation value is completely exhausted, i.e., how long will it take to “use up” the car? Is it 100,000 miles? 200,000? Is the intent to drive it until it stops running, or to sell it at some point and buy a newer vehicle? If this is the case, at what point does the vehicle have its optimum resale value? How does this optimum number compare with other vehicles?

Consider how these different perspectives affect the decision-making process:

If you sample a range of sources in the auto industry, they will tell you a new car loses between 15 and 40% of its value the minute it leaves the dealership. This means a new car with a $25,000 showroom price purchased Monday would likely be resold for $20,000 or less on Tuesday. From the perspective of capital expenditure, it makes a lot of sense to purchase the used car on Tuesday instead of the new car on Monday. Provided the vehicle is competitively priced and in good condition, buying a pre-owned vehicle is usually better than buying new. Except…

The reason for having a vehicle is transportation, not investment. The more you drive a car, the less it is worth. Older vehicles with higher mileage tend to incur more maintenance costs. In contrast, most new vehicles are less likely to require major repairs in the early years of use, and many of the most costly repairs will be covered by warranties. So while the cost of buying a used vehicle might be significantly lower, the accompanying maintenance costs could be much higher.

This same thought process, that transportation is an ongoing cost rather than an investment, leads to another conclusion: it doesn’t make sense to finance a depreciating asset. A lease agreement allows you to “rent” transportation for a known period at a fixed cost. When the term expires, you return the used vehicle and negotiate a new lease. In a sense, there is no investment risk with a lease – but there also is no opportunity for gain, either.

Given your assessment of the issues, it is possible to make financial arguments for leasing a new car as well as buying a used one. The decision hangs on how you assess the purchase of the vehicle; is it a monthly expense or a capital investment?

Outside factors that scramble the decision

Even if you have clarified your financial perspectives regarding automobiles, market conditions can make these parameters meaningless. A November 10, 2010 Wall Street Journal article titled “When Used Costs More Than New” highlighted a rare recent development: The current monthly payment for some new cars is lower than the payments for similar 1-year-old vehicles. How did this happen?

A combination of financing options, unexpected demand for used vehicles, and dealer incentives have made it possible for some consumers to buy a new car at a lower monthly payment than a one-year old version of the same model. New-car dealers are offering end-of-model-year rebates and special in-house financing terms to clear inventories. The result is a car with a higher sticker price but a lower monthly payment. For someone who doesn’t intend to keep the vehicle for its usable life, but replace it in three years, and plans to finance the purchase, buying a new vehicle may now seem like a smart move.

This example summarizes the external market forces that require you to constantly reevaluate your transportation decisions. The price relationship between new and used vehicles is constantly changing for reasons that are hard to predict. When gas prices were high, fewer gas-guzzling pick-up trucks and SUVs were sold, and fewer entered the re-sale market. As gas prices eased, the demand returned, which combined with limited availability, drove prices up. If you buy, what will the vehicle you are driving today be worth when you replace it? If you lease, how will the predetermined resale price match the market? What will it cost to replace this vehicle, whether bought or leased, three years from now? You can’t know the answers to any of those questions.

Most leased vehicles are financed and resold through the auto companies. Most used car loans are made by local banks. The cost of borrowing, whether to lease or buy, may be higher or lower, depending on the financial institution. Sometimes the financing costs are lower with the auto dealer, at other times the local bank has the advantage. Each time you’re ready to obtain a new vehicle, you must reassess the financing landscape.

The WSJ article mentions another factor: everything is different if you pay cash. If you can afford this option, it means you must also consider the opportunity costs. What would that that chunk of money used to buy a car be worth if it remained invested instead of exchanged for a car? At the end of five years, a car owned free and clear will be worth a fraction of its original value, while money that remained invested could have grown significantly. Are the transportation benefits from owning a depreciating asset really worth sacrificing money that perhaps could be allocated somewhere else? To learn more about our favorite financial strategies, check out our Ultimate Guide to Financial Planning Myths