Monday, 20 June 2011

Should I get a car loan?

by Rob d'Apice
Post-GFC, 'debt' has become a much naughtier word: at best, a necessary burden; at worst, the harbinger of financial ruin.

Debt does have a positive role to play in personal finance, particularly in building investment assets (and, of course, most often for property). But how about using debt to finance depreciating assets?

According to this recent Commonwealth Bank advert, it's the best idea in the world!

Something about this ad just screams 'evil'. Perhaps it's the baritone, sensual, Shakespeare-inspired narration; perhaps it's the 'Meet Joe Black' suited Commonwealth Bank personification that happily hands the car keys to the helpless, naive youth; perhaps it's the allusion in the final line ("Happiness...") that a personal loan can bring young people all the joy and fulfilment that comes with the immediate gratification of acquiring things you can't afford, without any future consequence.

Yep, it's probably that last thing.

What's really so bad about buying a depreciating asset with debt? It's fairly simple: you're burning money on both interest (the money you owe the bank for your loan) and depreciation (the amount of value you lose in your car each year), and that means losing a lot of wealth.

Meet Kim and Tim

Kim and Tim are twins. They both have savings of $5,000, both have $400 per month of spare income to go toward savings or assets, and both desperately want to get some wheels.

Kim is an aspiring high-roller and wants a brand-spanking new VW Golf for $22,000. She puts in her $5,000 cash and gets a $17,000 personal loan from the good people at the Commonwealth Bank. Her $400 per month is going to the bank to pay off the loan

Tim, on the other hand, wants to save up for some property; he opts to buy a used car online for $5,000 - a 2001 VW Golf. He puts his $400 per month into an online savings account.

Meet Kim and Tim, 5 years later

In just 5 year's, Tim's wealth is now more than double that of Kim's. It's clear that Tim will be better off, but it's quite stark how big the difference really is.

Each person's net wealth can be considered as the sum of their car's value and their cash savings, less any outstanding debts they have.

Overall, Tim ends up with around $33k, made up of $30k in cash and $3k value left in his car. Kim's car will only be worth a bit over $12k, and she'll have just $3.5k in savings - less than half the total wealth of Tim.

So who took Kim's money?

There are two things that really hurt Kim.

1. Kim lost nearly $10k in her car's depreciation, Tim loses only $2k. We've taken our depreciation assumptions from a Choice guide to car depreciation: you'll lose about 14% of the car's value in the first three years, then about 8% per annum for the remainder. In reality, the cliché is true: as soon as you drive your car out of the dealership, you instantly lose a good chunk of money.

2. Kim will pay $5k in loan interest and fees; Tim will make about $4k in savings interest. It's well known that the path to wealth is to accumulate income-generating, capital-gaining assets, rather than load up with debts for depreciating assets. The difference in Kim and Tim's interest exposure is clear evidence of this.

A blow-by-blow account

Don't believe us? For the more numerically curious of you, we've mapped out Kim and Tim's financial position for the first five years to show you what drives the changes in their wealth.

What about running costs?

Yes: in this analysis, we've ignored the running costs of the cars. A new car under warranty often has free service for the first few years of the car's life, and registration doesn't require an inspection. On the other hand, comprehensive insurance can be more expensive (because the car is worth more). A newer car may also be more fuel efficient. While all these things are true, even if Tim's running costs were $1k more than Kim's every year, he would still be well ahead of Kim's financial position at the end of year 5.

What's your experience with car loans or personal loans? Do you have one? Has it worked for you? Let us know in the comments!


  1. I've wondered about this car situ but later down the path... My car is becoming quite $$$ as it gets older. It's now 10 years old and ain't gonna last forever. Therefore, am I better to sell it now and get something newer, or just let the old one run itself into the ground?

  2. Good question! It is generally more financially cost-effective to keep an older car, but it really depends on how expensive maintenance on the car has become - which is driven by the make, model, # of km and service history of the car.

    For it to be financially prudent to sell your car, the savings you would make in services/maintenance each year would need to outweigh the combination of 1) the increase in depreciation you suffer each year with a more expensive car, 2) the cost of 'locking' more of your money away in a more expensive car and 3) the 'switching' cost - mostly stamp duty and sales commissions...

    Do you know:
    - roughly how much the car is costing you each year (split by services/maintenance, rego, & insurance)?
    - the approximate sale value of the car?

    If give us those two numbers, we can work out something more quantitatively rigorous!