Watch out for Vehicle Depreciation

Jake - Author/Founder

Jake - Author/Founder

I'm Jake. I believe you can build a wealthy life through frugal living and index investing.

     Key Takeaways

  • Loss of a vehicle’s value should be viewed as an expense.  
  • The average vehicle depreciates 20%-30% in the first year and 15% each year thereafter.
  • Luxury vehicles lose value the fastest. 
  • Brands known for reliability hold value longer.
  • Research depreciation, maintenance, insurance & fuel costs to gain a holistic understanding of your vehicle expenses. 
  • Buying a 2-5 year old vehicle is the sweet spot for minimizing depreciation expenses while ensuring you still have a reliable and modern vehicle.
  • Understand the opportunity cost of vehicle depreciation. 

Introduction

I’ve seen countless 18-24 year-olds drop the majority of their annual salary into a vehicle. They then go on to realize that most of the vehicle’s value is gone 3 years later. I was guilty of this myself when younger, and I wish I understood vehicle depreciation earlier.

What are the two biggest purchases in a lifetime? Most would say a home, followed by a vehicle. One major difference between the two is that the vehicle declines in value over time (depreciates) while the home generally gains value over time (appreciates). Depreciating assets take away our net worth, while appreciating assets increase our net worth.

A vehicle can be a status symbol that communicates wealth. There is nothing wrong with having a brand new, or high-end vehicle under two conditions. Firstly, you must be able to afford it. Secondly, you must understand the true cost of owning a vehicle, along with the associated opportunity cost, to make informed decisions. 

Dropping a large fraction of your net-worth on a vehicle is a poor decision if your goals are to increase your wealth. and achieve financial freedom.  

The single decision to purchase a vehicle is also a decision to absorb a series of future expenses. These future expenses include insurance, maintenance, and fuel costs. However, depreciation is the largest, and most frequently overlooked annual expense for new vehicles. I call this type of expense an environmental expense; see this article for a closer look at environmental expenses. 

By purchasing a high-priced new vehicle, we also eliminate the opportunity to invest this money into assets that can pay us money and increase in value such as stocks, bonds and real-estate. 

Aim

The aim of this article is to help you quantify your vehicle depreciation expenses. This will help you manage your expenses to grow long-term wealth.

What is Depreciation?

Depreciation is a loss in value over time. The total depreciation expense over a given time is the difference between the purchase price and the selling price. The annual depreciation expense is the drop in value over a one-year period.

The depreciation rate is expressed as a percentage of the asset’s (your vehicle) value that is lost in a year. For example, a 15% depreciation rate means that the vehicle’s value at the end of the year will be 15% less than the value at the beginning of that year.  

The practice of treating loss of value as an expense is nothing new. Businesses treat decline value of there machinery and buildings as an annual depreciation expense – there is no reason why you should not do the same! 

Determine the Depreciation Expense for Your Vehicle

The average vehicle depreciates 20%-30% during the first year, and 15% per year for the following years according to Blackbook, a firm that performs vehicle valuations.  

The overall annual depreciation expense is determined by two factors. The initial value of the vehicle (MSRP), and the depreciation rate. More expensive vehicles suffer a greater depreciation expense given the same depreciation rate. 

For example the depreciation for a $10,000 vehicle with a 25% first year depreciation rate will be $250 (0.25*$10,000 = $250). A 25% first year depreciation rate for a $100,000 vehicle will be $25,000. 

Not all vehicles depreciate at the same rate. Expensive luxury vehicles depreciate at the highest rates according to BlackBook, while cars known for longevity and reliability depreciate at lower rates. 

When considering total ownership costs, a more expensive vehicle will also have higher insurance and maintenance costs. Mileage, maintenance records, accidents and modifications also impact depreciation rates.

Assumes a 25% loss of value in the first year and a 15% loss in each following year.

You can use my depreciation calculator at the button above, or you can use Edmunds True Cost to Own Calculator to estimate depreciation costs for your specific make and model.

Depreciation: New Versus Used Vehicle

A used vehicle will have a lower depreciation expense for two reasons: the steep 20%-30% first year depreciation was avoided, and any further depreciation expenses are applied to a lower overall asset value. 

I’ve built a plot to compare depreciation expenses by year of ownership for a new 2010 Honda Civic compared to purchase of the same model at 6 years old.  

Annual depreiciation expense by year of ownership for a 2010 civic, comparing the vehicle new to used.

So What's the Best Age to Buy a New Vehicle?

So, what is the best age to buy a vehicle? Depreciation expenses go down with vehicle age, but maintenance expenses increase with age. Therefore, the optimal balance must be achieved between declining depreciation expenses and increasing maintenance expenses. 

In addition, vehicle reliability should be considered along with the valuable time spent booking maintenance appointments and waiting at the shop. 

The consensus is that a vehicle age of 3 years old is the sweet spot. This age yields optimum balance between depreciation and maintenance expenses. Read this article for more detail on why purchase of a vehicle at the 3-year mark is optimal. 

Opportunity Cost of Depreciation

Opportunity cost is the forgone next best alternative use of the money allocated to the depreciation expense. You can find the opportunity cost by answering this question: What is the next best thing that you could have done with the money that was allocated to the depreciation expense? 

I would personally view investment of this money in the S&P 500 index as the next best opportunity – the index has yielded a 10% Compounded Annual Growth Rate (CAGR) since 1923 [Investopedia, 2020]. 

For example, if I purchased a new $50,000 Doge Ram, I would have incurred $27,000 in depreciation expenses over 4 years. The opportunity cost of this depreciation expense over the four-year period would be investing the money at a 10 return, equating to $36,044 at the end of year 4. 

Example: Jakes Car, 2010 Honda Civic

I purchased a used 2010 civic in 2016 for $6,000, the car was six years old, had 118,000km with no body rust, new tires and new brakes.  This car sold for $16,500 new in 2010. My annual vehicle depreciation expense has always remained less than $1,000 per year and currently resides just below $500 per year.

I have driven 85,000 km since 2016 and my maintenance costs have been limited to a new AC compressor, front brakes and routine oil changes. I conduct all of my own maintenance, so my tolerance for older vehicles is much higher than average. My total vehicle ownership costs are around $150 per month, including insurance, maintenance, depreciation and fuel. The rest of my money goes into assets that will grow in value!

I will continue to drive this vehicle until at least 2025. Depreciation expenses will continue to drop, while my income will increases. The difference will be invested into growing assets.

Conclusion

The purchase of a vehicle is a huge financial decision, and vehicle depreciation is the largest expense associated with any new vehicle. Depreciation normally exceeds insurance, maintenance and fuel costs. An understanding of depreciation is therefore critical to for informed decision making.

A new vehicle will generally depreciate between 20% and 30% in the first year, and 15% during each following year. You can research the depreciation expense for your specific make and model here.

In addition to depreciation, a a vehicle imposes a series of negative cash flows for maintenance, insurance and fuel. Keeps these costs in mind and remember that your hard earned money can also be used to purchase assets that go up in value while providing positive cash flow. I leave it up to you to make your decisions from here.  

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