FOOL'S EYE VIEW
The Economics of Changing Your Car

By Rob Davies
May 3, 2001

Carburton Street, London -- Despite the protestations of the anti-capitalists this week most of us have little choice about car ownership. We simply have to have one to go to work, go shopping, visit friends and relatives and all the other uses we find for them. Owning a motor car is probably the third largest financial commitment that most of us make after our retirement savings and a house. However, there is no doubt that they are expensive, and financing the car habit is a major burden.

Nigel Roberts (TMFNigel) wrote an excellent series of articles on the in and outs of buying a car, which you can find here. However, the issue I want to cover here is the thorny problem of replacement. Most of us have a car already and we know that it is steadily losing value but, provided it keeps going and we are not too image conscious, we are content to keep driving it. Some people, like Nigel, enjoy the process of changing cars, but personally I find it a hassle and the sort of thing I avoid as much as possible.

Nevertheless, the annual MOT and six-monthly service bills remind us that the machine is getting older and needs increasing amount of TLC from the garage mechanics. The trouble is they charge £30 an hour and the longer it stays there the more it costs you. After a while you also get the problem that spare parts are not kept in stock and, eventually, the whole exercise of keeping the car maintained becomes more trouble than it's worth.

So the critical question is: where is the crossover point? When does the cost of buying a new (or at least newer) car make more sense than running an older one? A lot depends on the age and reliability of the car, and whether it is a new or used one. However, a simple way of looking at it is to take the financing cost of a newer car and compare it with the amount of money you are spending on maintenance. When the servicing cost exceeds the finance cost it makes sense to change.

As an example, consider a £10,000 car with £5,000 of finance at 10%. The interest is costing £500 a year, but on top of that we need to add the opportunity cost of the equity in the car. That is simply the cost of not having the money invested and earning a return. As this is short-term money we are talking about, the relevant rate will be interest rates on short to medium term deposits, say 4% after tax. In this case that amounts to £200 so the total finance cost is about £700 a year. But you only need a couple of bad services with, say, replacement disc brakes, before the maintenance cost will be equal to or more than that.

In his guide TMF Nigel makes the point very strongly that no one should buy a car on finance because the asset is depreciating so fast. It is not like a house that gradually appreciates. So how do the calculations work if there is no finance on the car? On that basis the money tied up in the car is only costing you the loss of the interest; say £400 in total. Of course if interest rates fall, or tax rates rise, the funding cost will fall as well.

You can get some idea of the probable running cost in the year ahead by the price of the guarantee the dealer offered you when you bought the car. If it was a wincingly large figure it's a fair guess that the garage knew you would be taking advantage of it. In other words there was a good chance that something would fall off or break in the year ahead. The other way of estimating service costs is simply to take this year's figure and add an allowance, say 10%, to cover the increase due to age. If that figure exceeds the funding cost then it probably makes sense to change the car.

All these arguments apply to motorbikes as well. And this is basically a rationalisation process to justify my purchase this weekend of a replacement for my twelve-year old Honda. It will cost an additional £2,000 (annual funding cost £80) but the alternative was to spend £400 on a new exhaust after having already spent over £500 on it this year so far. That's my excuse, and I'm sticking to it. I just wish I had made the switch before all those things wore out.

More: The Fool's Guide to buying a car