LIKE OUR ARTICLES? SUPPORT OUR SITE BY LIKING US ON FACEBOOK OR GOOGLE PLUS
January 20, 2013, Bedford, NY
by Jonathan Winter
Let’s go back in time several years to when we bought our first car (maybe longer than that for some of us!) You just entered the workforce and now needed to drive to your new job. Most of us did not have stellar credit at the time, first job, no credit history, you get the point. So we either needed a relative to loan us the money or we needed a co-signer. For the purposes of this article, let’s assume our rich uncle Fred lent us the money for a brand new $30,000 automobile. Because you were his favorite niece or nephew, Fred said, “Jonathan, I will lend you the money at no interest, you just need to repay what I lent you and not a penny more. I’ll even lend you the money over the expected life of the car, the next nine years, to keep your payments down.” Fred went on, “at 12,000 miles a year that is about 108,000 driven by the end of the loan. Cars are lasting longer these days and a car, if well maintained, they will generally last 100,000 to 120,000 miles and still stay remain in good condition; however you need to protect your uncle Fred from two things. The first is that you make sure you make your payments on time, every time. The next is that you need to take out insurance on your car so that if you get in an accident, I get my money back.” You think to yourself, “make my payments on time and take out insurance, okay fair enough.”
The next day, you and your uncle go to the Japanese car dealer and pick up a brand new hybrid automobile for about $30,000. You’re green by nature, so the hybrid is perfect for you. You thought about buying the car pre-owned, but since it’s your first car you thought, “why not – I deserve it!” Then you called the family insurance agent and took out insurance on your car. You chose a low deductible because Uncle Fred’s words were still fresh in your mind, “if you get in a wreck, make sure I get my money back.”
Three years go by and your hybrid is running like a champ. You’ve kept it in pristine condition: regular servicing, cleaning it inside and out two to three times a month, it still looks brand new! True to your uncle’s predictions your odometer reads about 36,000 miles. Then it happened . . .
After work one day you were driving home. Coming the other way was a driver who was committing an absolute atrocity. She was texting while driving. She crossed the yellow line and the two cars collided. Fortunately no one was hurt, but it was clear that your car was totaled. The worst part was that she was uninsured . . .
You called your insurance agent who brought the adjuster out the next day. “Yep, it’s totaled.” He said. “The Blue Book shows this car has a replacement value of $12,000. This is the amount that we will be writing you a check for today.”
“Wait a minute. I owe $20,000 to my uncle, I need $20,000, not $12,000 to pay off the loan! Besides, $12,000 isn’t fair, I still have more than 70,000 miles of life left on my car!” “That’s called “The Gap,” replied the adjuster. “That is the difference between a car’s financial value (the replacement cost if you bought it pre-owned with similar miles and age) and the value of the remaining life of the car.” He then went on to say. “Unfortunately buying a car is not like buying groceries.” You don’t consume it evenly over time. Cars plummet once you drive them off the lot. In the case of this car, given the miles, you probably had 6 or 7 years (or more!) of worry free life left on the car, but its financial value was only 40% of the original purchase price ($12,000/$30,000). Ironically, if you had bought it pre-owned, the GAP might have gone the other way!” he concluded.
Let’s examine this in more detail
Original purchase price: $30,000
Useful life left: 9 years
Cost per year $3,333
Expected, “worry free” miles left: about 110,000
At time of accident
6 out of 9 years left = 66% worry free life left
Expected, “worry free” miles left: about 74,000
$12,000 replacement cost on a car that cost $30,000 = the value is 40% of original purchase price
The difference between 66% and 40% is “the Gap.”
What is we had purchased the car pre-owned for $12,000 from the beginning? Given the story above we would have the following:
Pre-owned purchase price: $12,000*
Useful life left: 6 years
Expected, “worry free” miles left: about 74,000
Cost per year: $2,000
*A final word about “The Gap”
When buying your car pre-owned, the Gap represents potential profit for a car dealership. The more of it they can keep when reselling you a used car, the higher their profit will be. Most likely a three year old car with 36,000 miles will be a lease return, which means dealers will have the largest inventory available. In other words you will probably be buying the car from a dealership unless you are willing to do a lot of homework. Knowing the actual value of the car is key to negotiating the best deal for yourself. Check out Consumer Reports Used Car Buying Guide, The Blue Book or other periodicals of a similar nature to determine their bottom line price for the car.
As we conclude this note remember, cars are not like groceries, they do not decline over their useful life as they are consumed. For most cars the financial value decline is big in years 1, 2 and 3 and then the much slower in years 4+. The economic value decline is straight line based on miles driven. With cars routinely lasting 100,000 miles or more it makes sense to consider buying a used car. If well maintained, it’s hard to tell the difference between a three year old car and a three month old car. The saving however, can be astronomical.
Until Next Time