Another look at Cash for Clunkers: still a lemon

A closer look reveals even more personal wealth destruction

Based on feedback about my last Cash for Clunkers post, a lot of people have a hard time separating the politics of the issue from the economics. I can understand that. Our political leaders (from both parties) have become masters of the old magician's trick of misdirection. They distract people with a flourish of political rhetoric on one hand while they perform economic slight-of-hand with the other. It can be very confusing. After taking a closer look at this program, I see even more personal wealth destruction than I originally thought.

My interest in Cash for Clunkers is personal. The economic trials of the past two years were driven largely by poorly designed public policy that produced huge financial rewards for a relatively small group of individuals (primarily, the mortgage industry and Wall Street) at a huge cost to a vast number of regular families. Let's not fool ourselves. Cash for Clunkers is another politically-driven policy, brought by many of the same people responsible for the failed mortgage policies, and it will result in more wealth destruction for regular families.

My mission is to help people build their wealth, so I have a visceral reaction against wasted money. That is why buying cars has never been high on my list. A car is a wasting asset, meaning its value diminishes over time. Remember Ross Perot's "giant sucking sound?" For a lot of people that sound comes from buying, owning and operating cars. According to the National Automobile Dealer Association, the average price of a new car sold in the United States is $28,400. Next to a home, buying a car is the largest purchase most people make. It makes sense to be smart about it.

Brand new vs. Slightly used

When you are thinking about buying a car, the most fundamental decision to make is whether to buy a brand new car or a used car. A brand new car is exciting. The new smell is intoxicating. The look of envy in your neighbor's eyes the first time you drive it home is beguiling. But a brand new car is also a wealth trap. The moment you drive that brand new car off the dealer's lot, your wealth is going to take a hit.

To illustrate, consider the following information from Kelley Blue Book, a recognized authority on car values:

If I buy a brand new 2010 Toyota Camry, I will pay about $25,315. If I try to sell that car (in excellent condition and with low miles) one year later, I will likely get only about $19,555 (see the 2009 price in the table). In other words, my wealth declines by almost $6,000 or almost 23%. According to Kelley Blue Book, the trade-in value of the car is even less -- about $17,325 or 32% below my cost.

If I buy a one-year old used car in excellent condition from a dealer, Kelley tells me I should expect to pay $21,855. One year later, that car will be worth $17,675 or about $4,200 less than I paid. It's still a hit, but it is smaller than the hit I would take on a brand new car. I am spared even more pain, about $3,700, if I buy a two-year old car. No matter how you slice it, buying a car is going to be painful. However, you can reduce the pain if you buy a slightly used car.

Some people worry about getting stuck with a lemon when they buy a used car. That's a risk you face every time you buy a car, brand new or used. If you want to mitigate the risk with a used car, I suggest you buy a certified pre-owned (CPO) car from a factory authorized dealer. You will pay a little more than if you bought from a private party, but the certification process will give you more peace of mind. In 2003, I bought a CPO BMW 528i. It has been a great car. It now has 240,000 miles on it and still drives like it's brand new.

Some people are also worried that a used car will cost them more in maintenance. Again, a CPO car helps avoid that. At purchase, it will still be under factory warranty and it may comes with an extended warranty and 24 hour roadside emergency service. Finally, some people told me that a used car has a shorter service life than a new car. This may be true, but the price of that additional service year (if you buy a brand new car vs. a one-year old car) is very expensive.

Paying for it

Of course, you're going to have to pay for your new car. Most people end up financing their purchase over a 4 or 5 year term. Interest rates on new car loans are cheaper than rates for used cars (7.4% vs 8.3%) and you can often get longer terms with new cars. However, the slightly better financing terms don't compensate for the first year depreciation hit. Because you are financing a smaller purchase, your first year interest payments are still going to be less than buying the brand new car.

But the financing issue is more fundamental than interest rates and loan terms. Paying interest to own a wasting asset is perfect recipe for wealth destruction. You can think of it this way: Every dollar you invest in a car melts at a rate of about 10% per year over the first four years. If you put 10% down and finance the rest at an 8% interest on top of that, your wealth will melt at a rate of 17.2% per year (10% depreciation + 8% interest on 90% of the purchase price). You will never build wealth facing that kind of math.

Pulling it all together

 The Cash for Clunkers program does not change these economics. Using numbers from Edmunds.com, another reliable source of car information, I determined in my last Cash for Clunkers post that a typical buyer will pay $3,000 more for a Cash for Clunkers transaction than they would pay by trading in their clunker on a certified pre-owned car.

Another troubling aspect of Cash for Clunkers is that it entices some buyers to scrap fully-paid for and perfectly serviceable vehicles in exchange for a new car and a whole lot of debt. Before the Cash for Clunkers transaction, these people were actually rebuilding their wealth. Now, Cash for Clunkers has put them back on the path of wealth destruction.