Car loans – should I finance my vehicle with a car loan?
I have read many articles recently, and a bazillion questions on reddit, regarding the financing of new vehicles and whether it is a good idea to buy a new vehicle with a car loan.
Short answer – no, it really isn’t. Please don’t do it. This is probably best explained through an example.
Cost of a brand new car with a car loan
We shall base our example on a Ford Fiesta – the UK’s best selling car. The list price for a Ford Fiesta Zetec 5 door 1.6L is £15,345.
Imagine that we finance this vehicle over 5 years with a car loan at a 4.9% APR. Over the course of the 5 years, we would therefore pay a total price (including interest) of £17,673 for the vehicle.
Its residual value, according to a quick search on autotrader.co.uk for a 2008 Ford Fiesta Zetec with 70,000 miles (about average for 5 years), would be around £4,000.
Therefore, the net reduction in our net wealth over a 5 year period is around £13,700.
Cost of a 3 year old car without a car loan
So, now let’s assume we buy the same car second hand, but this time without a car loan.
Looking at a 2010 Ford Fiesta Zetec, we can purchase this car with less than 10,000 miles on the clock for £7,500 cash.
Its residual value after 5 years (looking at a 2005 car with 80,000 miles) would be around £2,300.
Therefore, the net reduction in our net wealth over a 5 year period is £5,200.
The aesthetic difference between a brand new car and a 3 year old car with less than 10,000 miles on the clock is negligent.
However, the difference in cost is almost £8,500 for the UK average car over 5 years.
Yes, there may be exceptions, but you should be very very careful. For example, if you can finance a vehicle for a zero rate or very low interest rate, this cheap debt may be used and you could place your cash in a higher interest investment.
However, these deals are usually only available on brand new cars you will suffer the problems above regarding depreciation.
Also, given the current low rates of interest on short-term deposits, this technique will carry a deal of risk to make the reward worthwhile.
TED agrees with me
You know you are talking sense when TED agrees!
To support my point, please also watch the excellent TED presentation below, where Preet Banerjee discusses the value of money. Watch it all, its good.
If you can’t be bothered, skip to 7:30. He highlights that the average household who continually finance cars though loans will spend around $162,000 in their lifetime in interest!! I hope this makes you feel as sick as it made me feel.
How much should I spend on a car?
On a getrichslowly.org article from a few years back, they suggest the 20/4/10 rule of thumb for buying a car. You should pay at least 20% down, finance for no more that four years, and the payment should be less than 10% of your income. The first part of this rule prevents you from owing more than the car is worth, and the last two parts prevent you from buying more car than you can afford.
The author goes on to quote an alternative approach from a twitter user, @ced1969, who suggested that we should “never finance a depreciating asset, like a car. Pay cash and immediately start saving for the next one”.
Well done ced1969, right answer! But this should not be our alternative thought. It should be our original thought!
My personal rule of thumb is: do not spend more than 5% of your gross income on the cost (purchase price less residual value) of a car.
This may seem low, but in the example above, it would mean that to obtain the “average” UK car, we would need to have an income of £20,800 (£5,200 / 5 / 5%). The average income in the UK today is £26,500. Therefore, to me, this seems about right. In the example above, the purchase cost of the average car (if bought the right way and ignoring maintenance) would make up 4% of the average person’s income.
So, what do you think about this percentage? It is much lower than other rules of thumb, but do you think it is too low? Let me know what percentage you spend on your car?
Incidentally, I spent 0% of my income on a car. I spent £350 on a second hand bike around 3 years ago which is still going strong! That’s the way to do it!! 😉