Buying or leasing a car

Aside from buying homes, purchasing cars throughout your lifetime is usually your biggest single expense. One important key to wealth building is to be smart about the cars you buy and how you finance them.

Like buying a home, buying a car is not simply about affording the price tag. There are the ongoing expenses of insurance, fuel, maintenance and repairs. Experts say you shouldn't spend more than 10% of you gross income on car related expenses. In the case of a couple, use the guideline of 10% of your combined gross income on your car or cars.

Cars are depreciating assets… the longer you own then the less they're worth. Because of this, it doesn't make financial sense to have a loan on a car.

Your costs add up

• You must paying interest (which, unlike a mortgage is not tax deductible),
• Pay for maintenance and repairs
• Buy insurance
  

Therefore, the more you can put down and the less you finance the better off you are in your long-term wealth building. Purchasing cars and paying high interest costs throughout your lifetime can rob you of money to retire. You'll have a good ride, but never get where you are going.

Buying a car

The first decision is to find a car you like in a price range you can afford. In a perfect world you pay cash for your car, however most of us must finance some or most of the cost of the car.

When you finance you will be making choices about how much to finance and the term of the loan. A rule of thumb is to finance no more than 80% of the cost. Cars depreciate most in the first year, so if you trade in a car you have financed over 80% within the first year, you will owe more on your car than it's worth! If you can afford the monthly cost of a shorter-term loan, you will save money. Long-term loans are attractive because the monthly cost is lower, but remember that you will pay the balance at some point, either by making payments through the entire term of the loan or by paying off the balance when you trade in.

After you decide on a car, the dealership will send you to the finance department. This is a major profit center for car dealerships. After they sell you the car, then they sell you a loan. Remember, the longer the term of the loan, the more interest they collect, regardless of the rate. Dealerships these days are offering very low interest rates but often on a 12 month loan. This means that you need good cash flow to take these offers because your payments will be steep.

Always negotiate the price of the car before you reveal that you are thinking about dealer financing. If they know ahead of time that you plan to finance, they will frequently try to confuse the issue by giving you a lower rate on a higher car price or a lower car price at a higher finance rate.

If you do decide to finance through the car dealer, you can negotiate the interest rate. Dealerships usually have several loan sources, including local banks and the manufacturer's credit company. Investigate other sources for a car loan such as your bank or credit union before you sign on the dotted line. Another possibility is to use your home equity loan or line of credit. With a home equity loan, you are borrowing against the value of your home. Not only are interest rates lower than those for auto dealer loans, but the interest on home equity loans and lines of credit are 100% tax deductible. If you do this, don't forget you are putting your most valued asset, your home, on the line to purchase a depreciating asset that can be stolen.

Leasing a car

Thirty percent of the people who got new cars last year decided to lease instead of buy. Lease payments are lower than auto-loan payments, so you can drive a car for less. However, dealerships have figured out that by promoting leasing, people buy more cars.

The leasing process begins when you pick out a car at a dealer's showroom. First, strike a bargain on the car price. For example, you might get a $25,000 car down to $22,500. When the lease is up, you can give back the car or buy it at a predetermined price, say $15,000. Your monthly payments are based on the $7,500 difference between the car's upfront costs and its end-of-lease price, plus interest and incidental expenses. In a sense, you are financing the depreciation cost of the car. This is why they are able to make the payments so low.

Remember back to the beginning of this section. Cars depreciate, so you are making the best wealth building choice by paying cash. If you finance and own the car beyond the term of the loan you've financed, that's the next best wealth building choice. If you continually lease, you are paying the most over your lifetime because you are perpetually financing depreciation. You never get the benefit of transportation without the cost.

The benefit you do get is that you are always driving a fairly new car. This may be important to you. If so, it may be worth paying for.

Unfortunately, because of the salesmanship of car dealers and the attractiveness of a relatively low payment, people often unwittingly make their cars their major financial commitment. How would you feel if you looked back on your life and realized that you didn't get to do a lot of things, but always drove a great car? If you would feel good, leasing is for you. If you would have regrets, consider driving cars longer and/or putting more cash down up front.

 If you do decide to lease:

• Do not ask the dealer, "How much a month?" without negotiating the car's basic price. The dealer might then base the payments on the full sticker price or higher.

• Even if you negotiated a lower price for the car, the dealer could use a higher price to calculate your monthly payments - and you wouldn't know.

• You might intend to buy a car outright, and bargain down the sticker price. The dealer may then offer you a "special low-cost deal." You sign without knowing it's a lease or that the car price is higher than was agreed.

• Ask to see the calculations. Check the math. Know the true price of the car that you're going to lease. The term is referred to as the "capitalized cost," and should include incidentals such as fees, taxes and rust-proofing. The American Financial Services Association, which represents several large leasing companies, defines "cap cost" as the car's price after the down payment. This cost should be disclosed to you, the consumer.

• To minimize your costs in case you have to break your lease early, you want a low monthly payment and a low cap cost. If you intend to buy the car at the end of the lease, add up all the monthly payments plus the end-of-lease purchase price. The car with the lower total cost is the better deal.

• Remember: It pays to comparison shop!

Barbara Bachelder, CFP® for Wealth by Design, LLC