Updated: Jun 5
Car buying and financing thoughts from a Behavioral Economist, a Banker, and a Dad
First published on November 24, 2019.
This article explores car buying along a couple of different roads. As background, I’m an academically trained economist with experience in applied behavioral economics and risk management. Also, I have led lending organizations, lending-oriented consulting practices, and decision sciences companies.
However, nothing motivates me more to provide for the best car buying outcome than my young adult children and other people buying cars for the first time. Also, the majority of us buy cars so infrequently, that a refresher may be helpful prior to your next car buying experience.
Let’s face it, most people consider the car buying process as a “necessary evil,” right up there with visiting the dentist. Car buying is complex. Automobile costs are high, so it is important to decide on the best car. Our decision criteria is often a mix of emotional and objective considerations. How we rank our criteria is not always clear. The data used to compare alternatives is not always easy to obtain. Car financing alternatives just add more complications.
To cut through the complexity, below are car buying suggestions for first-time or infrequent car buyers. In this article, we provide several summary points. We also provide "Dig Deeper" resources. Think of this article as the summary to give you the "lay of the land." You may dig deeper when you are ready for that part of the process. This approach provides confidence you will have a positive car buying experience and achieve the best car buying outcome!
Step 1: Why buy a car? Approaching car buying with the proper mindset and motivation is VERY important. We recommend sticking to objective car buying utility statements like “For safe transportation.” Try to avoid emotional or less objective statements like, “Because I like the technology,” “I like how it handles,” “I like how fast it goes,” “I like the color,” or “I like the smell.” Use your objective “why” statement as your decision beacon. As you go through the car buying process, you will face choices laced with uncertainty. Use your beacon to mediate those uncertainties. Even if you decide on a more expensive car buying objective, our approach will help you optimize your car buying experience.
Dig Deeper: Please see our article Good decision-making and the nuances of accuracy and precision for how an accurate car buying objective mindset reduces bias and optimizes your car buying experience.
Step 2: Consider ride share and public transportation as a viable economic substitute for car ownership. We encourage you to build a simple business case. You will likely be surprised by the many hidden and cumulatively significant costs of car ownership.
Dig Deeper: See appendix 1 for our business case experience when comparing rideshare to car ownership. We also explore how typical cognitive biases impact attitudes.
Step 3: Assuming car ownership makes sense and as aligned with your car buying objective, your goal should be to minimize exposure to depreciation risk. The vast majority of cars depreciate. (I.e., go down in value over time.) Differing auto models have unique depreciation performance. Also, buying older cars helps reduce the depreciation risk. This occurs since the typical car depreciates quickly when it is newer and the depreciation curve flattens as the car ages.
Dig Deeper: See appendix 5 for the typical depreciation curve and the market considerations for buying a car.
Step 4: More specifically, your objective should be to buy a car to minimize the “cost per remaining mile” or "CPRM." That is, determine a standard useful life, like 120k miles, you expect regardless of the car you buy. Then, look to buy a car minimizing the expected remaining mile cost. Start by developing multiple car buying alternatives. Your alternatives should consider your car type preferences along with minimizing your costs. This is the stage to determine if a loan is needed and, if so, to obtain a financing pre-approval.
Dig Deeper: Appendix 2 shows an example of how the CPRM approach was able to minimize upfront costs, provide safe transportation and provide significant long-term value. We also describe the auto financing pre-approval process.
Step 5: Buy cars with good maintenance records that demonstrate a lower cost of ownership. The attached car buying workflow file has several model suggestions. This should include minimizing factory-provided car technology. Car tech is expensive to buy, expensive to maintain, and your smartphone with a car radio bluetooth connection likely has much of the needed navigation. Plus, your smartphone is likely a more reliable technology server. Why pay for tech twice!
Dig Deeper: Also, please see appendix 3 for how pollution may be considered when buying a car.
Step 6: Before buying, always have a trusted mechanic inspect a used car. You will likely need to pay a small fee and it is worth every penny! This is the step to evaluate alternatives and negotiate with the car owner. In today’s internet and data-driven world, it is important to curate your car purchase data and build your negotiating BATNAs.
Dig Deeper: Please see appendix 4 for a cautionary tale and a car buying process approach. Also, please see our article Negotiating success and building your BATNA for negotiating tips and the importance of building car buying alternatives (aka, BATNAs).
Step 7: Pay cash for your car or endeavor to get as small a loan as possible, and especially, at as short a term as possible. Paying cash and using this approach to buying a car could save someone $2,200 per year and provide $500,000 for retirement.
Dig Deeper: If you need a loan, see appendix 2 for thoughts on obtaining a car loan and the surprising long-term impact of auto lending.
Step 8: Be proud of buying your car like an economist! The car buying road has many cognitive bias potholes. It is this behavioral awareness and some process discipline that will improve your car buying experience and provide confidence you made the best car purchase decision!
Finally, you may ask "Does this approach work for electric cars, like EVs?" The answer is "Absolutely!" You will need to adjust the car models we suggest in the attached car buying workflow. EV technology is advancing rapidly. Unfortunately, used EV car batteries may not last as long as newer EV car batteries. I would be sure to understand likely battery life and any remaining battery warranty. As of the writing of this article, when using the CPRM method, I've found that used EVs are not as cost-effective as ICE. (Internal combustion engine cars) Through a combination of rapidly improving technology and government incentives, I expect EVs to quickly come down the marginal cost curve over the next decade.
Dig Deeper: Please see the attached excel file for our car buying workflow. This spreadsheet provides the background on CPRM. For more information on Electric Vehicle alternatives, please see this article The Best Used Electric Cars.
Car buying support
There is certainly more to buying a car than cost. You will also need to weigh your many preference factors. Such as model type (sedan, SUV, coupe, etc), size and type of the engine, handling performance, color, storage, technology package, and many others. Our brains have some amazing strengths, the preference weighting process is NOT one of them. Multiple criteria, costs, and multiple car alternatives create a burden for our brain to process. This is especially true since car buying is infrequent. For those in the car business, they train their brains to handle these decisions. For the rest of us, the volume of information and lack of process transparency may create confusion and a lack of confidence. This article and related “Dig Deeper” sections provide several decision resource suggestions.
Car buying decision apps are like “pocket confidence!” It is reassuring to know where you stand and when to walk away from a car sales negotiation.
Dig Deeper: The good news is, there are affordable decision science-enabled apps available to help! I suggest using simple and effective decision apps to help you weigh and order your preferences, costs, and car alternatives. I‘ve used Definitive Choice in the past. This app provides a convenient way to enter and weigh your car preference criteria, then, to enter your potential car purchase alternatives and their CPRM. Behind the scenes, it uses decision science to score each of your car buying alternatives. Ultimately, it gives you a rank-ordered report to help you understand which car alternatives will give you the biggest bang for your buck. Using a decision support app will 1) save you time, and 2) increase your decision making confidence!
1. Attitudes toward car ownership and ride-sharing:
As the former lead advisory recruiting partner at a Big 4 consulting firm and for a major university, I had the opportunity to interview many college students. As a core component of the interviews, I would typically provide a car economics-oriented case study. The case study goes something like this:
“Imagine you get a job in a major metropolitan area, you decide to live 10 miles from your office, and will commute daily. You have a choice of buying a car or using rideshare like Lyft or Uber. Take me through the business case to inform your decision as to the most economical transportation option.”
They then work through the case and compare the key cost categories and issues associated with each transportation option. As an interviewer, I’m judging the quality of their response, to understand how they structure business problems.
While I do not provide the interviewees the car cost categories, here are some typical reoccurring costs in case you wish to play along:
Fuel. The average cost is $1,681.50, or 11.2 cents per mile,
Maintenance and tires,
Licensing, registration, and taxes.
As a wrap-up question and as a curiosity, I ask the following question: “Assume now you get the data and calculate the case results. After working through the math, it is determined you are economically indifferent. That is, the cost of car ownership is the same as ride-share. Which transportation option would you choose and why?” I let them know there are no right or wrong answers.
Over time, the answers I have received are split down the middle. That is, about half the interviewees choose rideshare and the other half choose car ownership. However, the underlying reason is the same, and it relates to Freedom. I call it the Braveheart response. (after the Mel Gibson movie about fighting for Scottish freedom)
The car ownership crowd likes the freedom to drive whenever they want. The rideshare crowd likes freedom from the hassle of maintaining a car. Not too surprising, as freedom is a powerful motivator. Curious how everyone appreciates freedom but is split on how freedom is defined. Go Braveheart!
It would be interesting to learn how this attitude changes over a longer time period, especially as technology evolves.
Why ride-sharing is often discounted as a car ownership substitute: Behavioral economics suggest the most important factor driving the ride-sharing / car ownership decision is the salience cognitive bias.
The biggest expense of a car is a one-time purchase. That purchase may get spread over the habit-forming regular payments of a car loan. Once habituated, these payment activities lack salience. They are not as noticeable. However, getting a unique, asynchronous charge for every rideshare pick-up is very noticeable. In other words, it is the salient act of paying rather than the amount of that paying that is psychologically difficult. A related behavioral economics concept is called loss aversion. Based on human evolution, we are wired to perceive loss higher than an equally valued gain. As such, a frequent, highly salient ride sharing charge is like perceiving a frequent, painful loss.
So, it is one thing to do the business case. But even if the business case is overwhelmingly in favor of ride-sharing as a gain, the frequent payment salience loss will still be challenging. This is why thinking like a stoic may be challenging but is often very rewarding! (See Thaler, Sunstein Nudge, The Final Edition, 2021
List, The Voltage Effect, 2022
Kahneman, Tversky, Prospect Theory, 1979)
2. Comparison example, purchase with cash or financing:
Think of CPRM as an approach to common-size the remaining useful miles of different car purchase alternatives. It is a simple metric that makes different cars comparable. To see the CPRM approach in action, my son used his savings and paid $5,000 in cash to buy a used 2006 Kia Optima. He bought it in 2016. As of this writing, the car is still serving him well! As shown in the "Car Buying Workflow" attachment / "Auto economics" tab, buying a car could save you $2,200 per year and provide the equivalent of $500,000 for retirement.
Obtaining financing: As noted earlier, car financing should be avoided or minimized if possible. The long-term financial impact is significant. We certainly recognize auto lending may still be a practical reality for many people. As such here is our auto financing approach:
In appendix 4, we provide a process for identifying a car. As you initially research, you will determine the kind of car and price range you are targeting. Remember using an objective car buying statement like “For safe transportation” is important. Seek to avoid a “How much payment can I afford” objective. Make the payment an outcome of the objective process. This mindset helps minimize the potential long-term negative financial impact.
Based on 1), get loan qualified before going car shopping. The Bankrate Monitor website and LendingTree has a selection of direct auto lenders. Today, large auto lenders include Capital One and Bank of America. Also, many credit unions offer direct auto loans. Large credit unions include Navy Federal and PenFed. Check a few lenders, find the lowest rate and shortest term loan possible.
Some auto dealers provide indirect auto loans through their bank network. Seek to learn of the auto dealer's indirect auto financing options after you have identified the car to purchase. If they offer a loan program, use your direct loan approval for negotiation. Do not fear going back to the direct lender to ask for a lower rate.
With multiple loan offers from both direct and indirect auto loan sources, you are well-positioned to get the best rate and terms!
3. Thoughts on pollution:
From a strictly economic standpoint, car pollution like carbon monoxide emissions is a negative externality. This means the economic activity of driving a car creates a cost to an unrelated third party. In this case, the third party is society at large. Pollution can also be considered in the economic context of the “Tragedy of the Commons.”
According to The Economist,
“Today only 22% of the world’s greenhouse-gas emissions are covered by pricing schemes, and those schemes are not joining up”
In the case of the model presented in this article, costs fall under “Maintenance and lower cost of ownership.” Since pollution is not a direct cost, it is not overtly considered here. Good news though, pollution is considered in the “Remaining Miles” / CPRM calculation and the “Safe Transportation” car buying utility statement. This occurs because, generally, smaller cars and smaller engines provide safe transportation, have lower remaining mile costs, and are less likely to pollute. Thus, the CPRM approach is aligned with providing lower pollution alternatives. The CPRM approach will recommend cost-effective EVs as well.
Notwithstanding The Economist’s comment, it would not surprise me if the future pollution-related cost of ownership becomes more of a direct cost pricing scheme through carbon taxes, low carbon emission tax incentives, and related cap and trade schemes. It is my hope society is able to appropriately account for environmental costs. We are running out of time.
4. The car-buying approach:
In the pandemic-impacted world, car prices have increased significantly. Also, some car dealers "fudge" or withhold information found on car marketplaces like Trucar.com and Cars.com. (Another example of "the tragedy of the commons!"). This may make comparison shopping more difficult or confusing.
By the way, “sludge” is what behavioral economists call excessive frictions that make it harder for people to do what they want to do. Certainly, an auto dealer purposefully obscuring necessary car buying information is very sludge-like! Data fudging is a practice I observed with some auto dealers. This certainly does not imply all used car dealers are “sludgy.” It is important to beware.
Next are car buying best practices. These practices will provide confidence in your car buying decision! This approach is meant as a discipline to quickly weed out the car seller “posers” and provide you with high-quality car purchase alternatives. Think of this as an approach for applying many critical car buying filters. At each filter step, your car alternatives portfolio will be sculpted and fine-tuned. In the end, the surviving alternatives should be purchase-worthy. Also, start with the lower CPRM alternatives that meet your car buying preferences. That way, if the car survives the filters, you will finish the process faster and with less effort. This process is relevant for new and used car buying.
Definitive Choice provides a convenient app to identify and weigh your car preferences, plus add CPRM data. It tracks and orders your criteria and alternatives to help you get the most out of this process.
In our article The subtleties of lending discrimination, we suggest the following approach provides the added benefit for reducing economic discrimination. It is important to appreciate, economic discrimination is not necessarily race-based. Economic discrimination may occur to anyone.
Car buying best practices
Build multiple credible used car purchase alternatives before leaving to inspect cars in person. The attached car buying workflow may be used to organize your alternatives. Inputting the used car data from marketplace apps is a good starting place. If auto financing is needed, now is the time to line up an auto loan. You should strive to start with around 10 alternatives. See appendix 2 for related information. There is certainly more to buying a car than cost. You will need to trade off or weigh many factors. Such as model type (sedan, SUV, coupe, etc), size of the engine, handling performance, color, storage, technology package, and many others. You may use helpful decision software to help you weigh your alternatives.
Developing BATNAs when negotiating is critical. In the negotiation process, always: a) let the auto dealer know you will be comparing several cars from several dealers. b) be respectful c) ask lots of questions, and d) most important, be willing to walk away.
Call ahead and validate the key information. If the seller is unwilling to provide the information, go to the next car. If you get to the seller and the car is not as represented, go to the next car.
If the car meets your expectations, take it to a trusted mechanic to get a "pre-purchase" inspection. Having a qualified and independent perspective is critical! A pre-purchase inspection provides an itemized and priced list of maintenance needs. If the seller is unwilling to release the car for inspection, go to the next car. If the pre-purchase inspection reveals significant defects, go to the next car. Determining defect significance is judgmental. I anchor my judgment by asking the mechanic this revealing question: “Would you buy this car for your son or daughter.”
Use the pre-purchase issue costs to negotiate the price. If the pre-purchase inspection defects are not too significant and you are ready to buy, it is still likely the inspection revealed minor deferred maintenance issues needing to be fixed. Use this to negotiate down the price with the seller. At this point, BE REASONABLE. Used cars do have normal maintenance needs, so the seller may not wish to back off the price for the “standard” life of car maintenance. As a rule of thumb, I seek to split the cost of repairs with the seller as a reasonable middle ground. See appendix 2 for thoughts on auto financing. If financing is needed, this is the step in the process to confirm car funding via your financing source.
Be aware of the used car source. Many new car dealers source their used car inventory from new car trade-ins. Many used car-only dealers source their car inventory from auto auctions, like Manheim. Be careful with auto auction sourced cars. These cars are often auctioned from bank repossessions. It is more likely the previous owner of a repossessed car did not take care of it as well as you would like.
Consider Facebook marketplace or other "buyer/seller direct" marketplaces. Buying direct from the previous owner may provide a higher quality car source. Rarely do repossessions get sold on direct marketplaces.
5. Typical depreciation curve and market considerations for buying a car:
The “Here” on the graph is known as the inflection point. This is the point that value deceleration slows to where car values decrease at a decreasing rate. (In math language, this is where the second derivative of the estimated curve is about 1.) This is a good model vintage to consider buying.
Typical drivers of depreciation:
Actual wear - this also relates to maintenance costs, an expensive to maintain car will drop in value faster
The new car market - a strong new car market may depress demand for used cars
The used car market - this may relate to 1) seasonal, like the time of year new car trade-ins may enter the used car market or 2) cyclical, like when leasing residual and used car market imbalance may drive large lease cancellations and autos entering the used car market. Also, in a declining economic cycle, car loan repossessions may create an increase in used auto supply.
Salvage value market - may be driven by government programs like “Cash for Clunkers.” Think of salvage value as price support as the car ages.
Upon solving the second derivative across the vintage years (x), the 5th car vintage year is closest to 1. So, target buying a car at least 5 years old to reduce depreciation risk. Our CPRM model is an approach aligned to identifying cars with lower depreciation risk.
In case interested, this is how the math works regarding the optimal model year:
The above depreciation curve has the following estimated functional shape formula:
y(hat) = f(x)= -.318 ln (x) + 1.0011
and the second derivative:
Upon solving the second derivative across the vintage years (x), the 5th car vintage year is closest to 1.
Could one attempt to estimate individual depreciation curves for each car model? Sure. With enough data, expertise, and time anything is possible. Actually, auto lender risk management organizations do this to help them understand loss, loss reserving, loan pricing, CCAR requirements, etc. However, for our purposes, this would be overkill! Just knowing the 5th year is generally the car depreciation curve's inflection point provides most of what we need to know about depreciation when buying a car.
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