Car Buying Methods and Costs

Car Buying

Methods and Costs of Buying a Car

As Karen Lundergaard notes in her 2002 article "How Should I Pay for My Car?" In the Wall Street Journal, there are many factors that must be taken into consideration when attempting to assess the financial incentives of the various methods of purchasing a car. Though cash buyers almost always get the lowest price, it also requires a major layout of capital that cannot be invested. The higher costs of financing or leasing -- through both price paid and/or interest on the loan -- must be compared to the lost interest that could have been earned form the cash layout. Other things to consider include tax deductions and trade-in value, all of which make the situation more complex, especially for a large business. Most of the analysts in the article still generally recommend a cash purchase when possible, but in the current climate this might not be the cheapest alternative.

The Honda Civic sedan is a fairly average new car that begins at the modest price of $15,655. Having spoken with the dealer regarding this price, a cash buyer could negotiate a series of upgrades to the interior and to certain performance aspects of the car and end up paying only $16,000. Five percent sales tax (an approximate national average) brings the cost to $16,800. Tax deductions could be made based on yearly depreciation or all at once; this latter option provides a tax savings of $4,000 at a 25% tax rate. If the cash were instead invested in a CD at 4.5% per annum, it would earn an additional $3,938.91. In essence, then, the tax savings and the return if the cash were invested cancel each other out, and the care costs the corporation almost exactly what was paid. Hondas tend to hold their value well, which also must be considered -- after five years depreciation, the car at trade-in will be worth slightly less than half of what was paid, generating an additional savings of approximately $7,000 in five years time.

Leasing a car involves essentially renting the vehicle long-term; there is no trade-in value at the end of use, and interest is charged throughout the course of ownership. The purchase price itself is generally higher on a leased vehicle, as well, although the lessee typically pays approximately half of this value (plus interest) and the much lower initial cost does allow capital to be invested elsewhere. Assuming a price of $18,000 (standard for the upgraded Civic Sedan LX and a lease agreement of $9,000, the standard Honda leasing agreement with no down payment (for qualified buyers) will cost a total of $12,436.56 including sales tax, according to Honda's online lease calculator. Using the same initial investment of $16,000 in a 4.5% per annum CD less the annual cost of car payments brings the final balance of the CD to $4,669, or approximately one third of the total purchase price of the vehicle. This does not compare favorably to the near-half value of the trade in with a cash purchase.

A purchase financed through a bank or other lender will be treated by the dealership as a cash purchase, and the car can be obtained for the same price. Assuming a standard down payment of ten percent ($1,600) and an interest rate of 3.5% (.25% above prime) over 36 months, the total cost of the car would be $17,590, including sales tax. Monthly payments would come to $421.95. Investing the principal of $16,000 in the same CD, less the annual costs of payments, would not have a positive balance at the end of three years -- the initial outlay is too great to be overcome by the interest rate that is only 1% higher than that of the loan payments. This would allow the company to absorb the cost of the car at a slower pace, and retains the same trade-in value as the cash purchase, but over a three-year loan the cost is still higher.

Financing through a dealership is not always advisable, but in the current climate nearly every manufacturer is offering zero down and zero APR for the first year for many qualified buyers. The purchase price of the vehicle will jump back up to the $18,000 range for a non-cash purchase, however, and interest will be applied to the second and third years of the loan. Interest rates are likely to go up, but for the purposes of this analysis we will assume that the loan is charged a rate of 4% in the second and third years (though it will likely be higher). The total cost of the car, then, would be approximately $19,300 with sales tax. The CD investment would yield a final balance of $350 after three years, not nearly enough to offset the additional costs of financing the care even at the better rate -- the higher cost of the non-cash purchase eliminates any benefits that might have been obtained through the lower outlay of initial capital.