<<<<<<<<<< Go back to Part 1
So, this is the second part of the case study. Hope you enjoyed part I. Let me start with a picture of my 10 years old Hyundai which I eventually had to sell to scrap buyer. Let the study continue here.
How much does it cost to own a $45,000 mid-range luxury sedan over fifteen years? The three tables below summarize the average annual cost of owning a $45,000 mid-sized sedan over three consecutive five year periods. Purchase taxes, fees, and other acquisition expenses are assumed to be an additional $5,000 for a total acquisition cost of $50,000. Representative examples of these cars would be from the mid-range of models made by luxury car manufacturers, such as Audi, BMW, Lexus, and Mercedes.
I will leave it to you to make comparisons and to draw your own conclusions about the long-term cost of owning a lower priced sedan versus a luxury sedan. I will limit my commentary about the purchase of a luxury sedan, because I admit that I am rather biased. It all comes down to the value of current consumption versus your desire to save more and grow your wealth.
Frankly, I would never buy an expensive car, because long ago I realized that I cared much more about saving money and investing than I did about owning a shiny prestige car. This realization came one day sitting in dreary, stalled Silicon Valley commuter traffic during the 1980s. There were many other nicer cars than my VW on the road, but we were all creeping along at the same rate. Many of the other cars near me in the commuter pack could have left my VW in the dust on an open road without the highway patrol nearby. However, for most real world driving these other sports cars and luxury cars had no great advantage over mine. They were locked into the same slow commuter traffic just like I was, but every slow mile they traveled was costing them much more than my VW was costing me.
I realized that all I really needed in a car was enough room for by 6′ 6″ body to be reasonably comfortable, and that need was satisfied by a decent quality bucket seat. Beyond that all I cared to have was a nice stereo and some air conditioning, when necessary. I also realized that I did not want to spend the rest of my life working and that a habit of buying expensive cars was more likely to keep me in the slow commuting crawl for more of my life.
Instead, I have owned less expensive cars, and I have invested the difference. I retired from the corporate world at age 51. For over a decade since then, I have amused myself as a part-time financial author, investment advisor, and financial planning software developer. My morning commute is from upstairs to my office downstairs. My old cars sit quietly in the garage. Sadly, the VW is long dead.
With a daughter going to private lower, middle, and high schools and now in college, I reflect back on that decision to buy modest cars and run them into the ground. In total, sixteen years of educational expenses are a lot like buying 12 to 15 mid-sized sedans or 6 to 8 luxury sedans. I can’t image having bought that many cars. However, I can see that by owning inexpensive but reliable cars for a long period, I have saved enough to pay for a few years of that huge education bill!
How to model life cycle car ownership costs
Because there are many variables that affect automobile ownership costs, it is necessary to define a model that is both reasonably robust and based up fact, while being general enough to not get lost in details and variability. This section describes the major components of this auto ownership cost model. Subsequent, sections use this model to analyze the costs of owning a mid-sized sedan and a mid-range luxury sedan.
* A fifteen year auto life broken up into three five-year periods.
This model assumes that the maximum potential lifecyle of most cars is about fifteen years. By breaking these fifteen years into three periods, we can understand which cost factors are most important at various points over the life cycle of a typical automobile. Also, different car owners tend to have different car ownership patterns. Many car owners sell their cars after four or five years and buy a new one. These owners are less cost sensitive and prefer not to deal with the occasional challenges of keeping an older car on the road.
In contrast, new car buyers who own their cars for up to ten years are willing to deal with more problems, but they are happy to own a car without having to make payments. Those intrepid owners who keep their cars for up to fifteen years and well over 100,000 miles intend to run those cars into the ground and are happy as long as their mechanical beast keeps running.
* Automobile purchase costs for each five year period
The tables above list the total cash price of the new car plus purchase taxes and fees. At the end of each five year period an end-of-period residual value is indicated. To measure the cost of the car purchase over the first five year period, end-of-period residual value is subtracted from the inital total cash price with taxes and fees. This difference is then divided by five to estimate the annual purchase cost. The residual value for the first five year period became the initial fair market value for the second five year period, and so on with the third five year period.
To estimate purchase costs for both the average mid-sized sedan and the average mid-range luxury sedan, price information for a variety of representative manufacturers. Data sources were Consumer Reports and Kelly Blue Book. The Kelly Blue Book website provided estimates of the residual values of various models at the end of five years and ten years.
After fifteen years, any running car will have a positive resale value, however small. Nevertheless, the fair market value at the end of fifteen years is set to zero dollars in this financial car cost-of-ownership model. The zero value assumption at the end of fifteen years is designed to capture the full acquisition price within the expense model. Except for collectible automobiles, after fifteen years, few cars have much value unless then are in excellent or very good condition. For most old cars that are in average or lesser condition, the cost of bringing those cars up to at least very good condition will exceed the market value of such cars in very good condition.
* Investment opportunity cost
The five-year periods allocate purchase costs depending on the beginning and ending fair market value of each period. Nevertheless, when an automobile is purchased the cash to buy it changes hands at the outset. Therefore, there is an investment opportunity cost for this consumption expenditure. Had the cash asset not been spend on a car, that financial asset would have had the opportunity to earn an investment return.
To calculate the investment opportunity cost, the model assumes that the buyer could have earned a compounded 5% real dollar (constant purchasing power with inflation extracted) investment return across the fifteen year period. This 5% real dollar (8% with inflation) assumption is approximately the return that a broadly investor with very low investment costs could have achieved over the past 85 years with the average asset allocation of 60% stocks and 40% bonds and cash. Due to investment compounding, with a 5% real dollar return the investment opportunity cost would continue to rise over the fifteen years. Furthermore, given market volatility and bull and bear markets, the true investment opportunity cost would likely be highly variable.
* Operating costs
Operating costs include fuel, insurance premiums, normal maintenance, and repairs. The February 2014 Consumer Reports article entitled: “Best new-car values” pages 50 to 52 was the source of assumptions about operating costs. This article provided total cost of ownership estimates on a cents per mile basis over the first five years of car ownership assuming driving 12,000 miles per year. The cents per mile costs of appropriate models were averaged and were multiplied by 55%, since Consumer Reports figures included capital costs over the five year period which were “almost half” of the cents per mile figures provided.
During the second and last five year periods, it was assumed that the cars were properly maintained at recommended intervals to maintain constant operating efficiency. For the $25,000 mid-sized sedan, an additional $800 per year was added for repairs during the second five year period and an additional $1,800 per year was added for the last five year period. For the $45,000 mid-sized luxury sedan, an additional $1,600 per year was added for repairs during the second five year period and an additional $3,200 per year was added for the last five year period.
These additional repair amounts are illustrative and arbitrary, but reflect realistic amounts that might be incurred after a car is ten years old. Of course, the incidence of repairs with older cars is highly variable. If you happened to buy a very reliable car and you were particularly lucky, these figures could significantly overstate your ownership costs, if very little breaks. On the other hand, if the transmission needs replacement on a mid-sized lower cost sedan, that could easily cost $4,000 to $5000. Replacing a transmission on an luxury sedan could cost several times that amount.
Since I need to own a car, is it fair to include the investment opportunity cost in financial lifecyle modeling?
An automobile is a capital investment that depreciates over time. It is appropriate to recognize the investment opportunity cost as one component of any overall cost of ownership model. The capital to buy durable goods is not free, and a price for that capital should be included and recognized explictly.
Of course, one can argue that in many circumstances a car is a necessity of life and might even be instrumental in gaining earned income. For many people, a reasonable argument can be made that a car now an absolute necessity of modern life. In suburban, rural, and urban sprawl areas outside the core of large urban center downtowns with good public transportation, there may be no viable alternative to owning a car.
With any major and absolutely necessary consumption item, one could argue that the money had to be spent and therefore, the cash that is used could not have otherwise have been invested to earn what is measured by the investment opportunity cost in this model.
It is up to you to decide how important the investment opportunity cost is to you in understanding the total cost to own a car. However, you should be carefully to separate the concepts of “need” and “want” in any consumption decision. If basic automobile transportation is required, then ignoring its investment opportunity cost is understandable. However, for the most basic transportation, there are cars cheaper than the $25,000 mid-sized sedans and $45,000 mid-range luxury sedans modeled above.
Nevertheless, a $25,000 mid-sized sedan could be an absolute necessity to you and you might choose to ignore the investment opportunity cost. That is fine, but keep this in mind when you compare the cost of higher priced $45,000 mid-range luxury sedans to the $25,000 mid-sized sedan. For the vast majority of people, it would be a big stretch to argue that they “need” a luxury car.
For most the difference in price between a $25,000 and a $45,000 sedan is a “want” rather than a “need.” Thus, for the luxury car model, I urge you not to dismiss the investment opportunity cost component of the model. At a minimum, consider the difference in opportunity cost between the two price categories, because you could have bought the cheaper sedan and invested the difference.
Cash purchase of a car versus auto loan debt financing
Regarding debt financing, many people, of course, take out usually take out a four-year or five-year auto loan to finance the vast majority of the purchase price. For them, it is still appropriate to use cash flow modeling method of this article. The purchase debt related to the auto purchase would be repaid within the first five year period, so any differences between a cash and debt purchase would show up in the first five year period. If the interest rate is high, some people will use accelerated debt payment software to figure out when paying faster than required makes sense.
The timing of cash flow payments would be redistributed over the first five year period. Nevertheless, if one used debt to finance an auto purchase, that will almost inevitably require a higher cash expenditure than paying cash at the outset. Therefore, if you would use financing to buy a newcar, then this model would tend to understate somewhat the cost of ownership.
Therefore, it would be appropriate to add to the capital cost to reflect the debt financing. In addition, do no be fooled by 0% or very low percent dealer financing terms. If there is a difference between the interest rate of financing from the dealer and the interest rate you could have gotten from a third party lender, then you probably could have gotten a lower cash price with harder bargaining. Low interest dealer financing is just another smoke and mirrors negotiation tactic.
The author of this article, Lawrence J. Russell, is a financial advisor and the developer of home financial software for retirement planning. He has also written some of the best personal finance books for Kindle and other ereaders.