Richer by the Day
Ongoing ramblings about personal finance, and all related topics. If it has to do with money, it will be covered here.

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Being frugally minded and debt averse I’ve always been proud to say that I pay cash for my cars. One of the cars in our household was bought new and the other one was bought used. After calculating the costs of buying a previous car for an upcoming post on the Lending Club blog, I’ve come to realize that paying cash may be costing me more for a number of reasons.

The main reason why paying cash for a new car costs more is the fact that new cars depreciate so quickly. As a result, leasing may be less expensive than paying cash and certainly less expensive than buying with borrowed money. To perform a reasonable comparison, I looked at the latest deal being offered at my local Honda dealer. Here’s what I found:

The vehicle in question was a 2008 Honda Pilot. The purchase price is advertised at $33,630. The same vehicle can be leased for $5,931 down then $279 a month for 36 months. If you bought the car, it would cost you $33,630 and be worth between $11,000-$15,000 after three years. That estimate comes from the blue book value of a 3 year old Pilot in good condition with 36,000 miles, the mileage allowance of the lease in question. Taking the high value of what the car would be worth, after three years, the car would have cost $33,630 - $15,000 = $18,630. The lease on the other hand would have cost $5,931 + $279*36 = $15,975. As you can see, buying the car would have cost at least $2,655 more just on money spent versus value after 3 years.

Next comes the opportunity cost of paying cash. Buying uses up $33,630 right now. If you instead invested that money (minus the $5,931 down payment on the lease and withdrawing the $279 payment each month) you’d still have over $20,000 after three years even if you were only getting a measly 4% APY. So after 3 years, instead of having a car worth at most $15,000, you’d have a bank account worth at least $20,000. Higher APYs make an even stronger case for the lease option.

Obviously owning a car for a longer period of time slowly makes paying cash a better deal. Since the lease basically cost you $5,325 per year ($15,973/3) your direct costs would be less if you owned your car for 6.3 years. The opportunity cost of not being able to invest that money would extend the break even point even longer. While there’s certainly something good to be said about a frugal person who keeps their car for a long enough time to make paying cash worth it, the reliability of such older cars as well as the maintainable costs will also start to become a factor.

What this exercise shows more than anything else, new cars tend to be an expensive means of transport regardless of how you pay for them. We would all be better served financially to go with a used car. For those who do opt for a new car, it would seem that a lease has many advantages over purchasing, even in cases where cash is paid.


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3 Responses to “Why Paying Cash for a New Car Costs More”

  1. Patrick Says:

    A flaw in the logic here is the 4% return. That’s hard to get now. Plus when you factor in fees and cap gains taxes it’s even harder. If you buy your car and own it for 10 years, the pay off for owning is better. Also, you’re not contractually obligated to pay for anything if you own the car. This is a good thing in a world where you might not have a job tomorrow.

  2. Mike Says:

    @Patrick: Thanks for your feedback. I certainly understand both of your points. My first point was that even without considering the opportunity cost of not having my cash available to invest, paying cash was still costing more in the short term. As far as finding an investment with 4% return, I wrote this post last July, when my HSBC direct account was giving closer to 5% (3.6% after taxes on the interest income). Now it yielding something like 2.5% Still, I have other investments that are coming back with 7%+ returns after taxes even in this economy.

    I agree that if you own for 10 years that paying cash may be better. But finding an investment that averages a decent annualized return over a 10 year period is also a lot easier. There is something great about not being obligated to pay each month. As I said, I paid cash for both of the cars I own. I’ve just found myself wondering if that was the right decision.

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