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Cars have a reputation for being a drain on finances. But if you know what the car salesman is up to, you can turn the deal to your advantage. That’s the message from Dean Gerber, a Chartered Accountant who works in sales and is steeped in the nuances of car finance deals. The reality is that you can probably afford a car that is way beyond your means. Ask yourself, though, if you really want to stretch your income to cover a new set of wheels. If you do – and we’re all human! – consider these tips and traps so that you make the most of your hard earned cash. – Jackie Cameron
Buying a car – a few common misconceptions
By Dean Gerber*
I often find myself trying to figure out how some people can afford their lifestyles. I’ll compare what I assume their income to be with an estimate of their expenses based on the cars they drive and the house they live in. Most of the time I have to conclude that they either inherited money, or that they’re living far beyond their means. South Africans generally live well beyond what they can afford – aided by credit that is often too easily available. In my opinion, there is no form of credit that is provided to the public in a more accessible way than vehicle finance.
Vehicle finance can be stretched out over 72 months, with massive balloon payments making even the most expensive cars accessible to the man on the street – like a tenant of mine who drove a car that cost more than the apartment that he was renting from me. A quote from one of my favourite movies, Boiler Room, puts it perfectly: “Everyone’s just waiting for the fifteenth of the month. It’s like they may drive a Porsche but they don’t have ten bucks to put in the gas tank”.
Financially educated or not, many people struggle to grasp the basics of how a car sale and finance deal works. It might be useful to point out some of the perhaps less obvious misconceptions that people have when buying and financing a vehicle.
Car salesmen are clever. Before they offer you a deal on a car, they first have to understand a few things about you. They need to know what is driving your decision to buy the car; they need to understand your financial circumstances; and most importantly in my mind, they need to have a feel for the psychological factors that will result in you ultimately buying the car and feeling like you got a good deal. This is why car dealerships are typically flexible in terms of the ways in which they can structure a deal.
It might sound counterintuitive, but mark-ups on cars are generally extremely low. Dealerships make a large portion of their profit from volume rebates that they receive from the manufacturers for reaching targets, servicing and other value added services. So it is very important to them to have a high sales volume to drive other aspects of their business. In order to drive sales, there is normally a certain value of “discount” available in any given deal that the salesman can play with. For example, you are buying a R300k car and the available discount on the deal is R20k. The car salesman has a number of ways in which he can apply that discount depending on what he thinks will be most appealing to the buyer. He might even split the discount up and apply a combination of these options:
- Purchase price discount: In this case he applies the discount to the selling price of the car and sells it to you for R300k – R20k = R280k. He might be inclined to use this method for cash buyers.
- Trade-in assistance: The salesman knows that you have an old car that you want to trade in towards the purchase of the new car. He also realises that the more he can give you for your old car, the more likely you are to buy the new car. So he applies the R20k discount towards the trade-in. You are then more likely to buy the new car at his dealership because you believe that you may not have been able to sell your old car for that price anywhere else. I’ve also seen a salesman offer to “write-off” a portion of the balance outstanding on the old car (using the discount), which was quite a clever tactic in my mind.
- Financing assistance: When using the dealerships own finance or a bank to which they are affiliated, the financial institution will often structure a deal that will take the available discount into account. Think adverts that expound about car repayments at Prime less 2% or Prime less 3%. Do you really think that the bank/dealership is offering you a better interest rate than you could get on a loan on your most secure asset – your house? The sale and repayments are usually just being structured in a way that incorporates the available discount in the deal to offer you what seems like a more attractive deal. In many cases, the financial services provider may chip in even more of a “discount” on a particular structured deal in order to assist with driving the sales.
Now, I’m definitely not trying to insinuate that car salesmen are trying to trick their customers. All sales people and businesses are entitled to put forward their product in a way that will seem more attractive to potential customers. Banks, mobile operators and insurance companies all intentionally structure their products in a way that can be difficult for many consumers to understand – regulated as these industries may be. In any case, the above is really just a matter of allocation of the same discount into various options. It is up to you as a consumer to understand all options available to you and to ask the right questions.
Car finance terms
The thought process usually goes something like this: “I don’t know whether to buy car X or car Y. I prefer car X, but it costs R5 000p/m and car Y only costs R4 000p/m. I think I better go with car Y because it’s more affordable.”
Anyone who’s studied basic finance and understands the time value of money is aware that the monthly repayments are not very relevant to the purchasing decision. This is because you can structure the monthly payments to be whatever amount you please. Technically, you could pay R4 000 per month for a car that costs R800k or you could pay R10 000 p/m for a car that costs R200k. The bank assesses the deal based on your ability to make the monthly repayments, not on whether you can afford the purchase price and more importantly, the residual value. The monthly repayment is a factor of four things:
- The repayment term: The longer the repayment term, the lower the monthly repayment.
- The interest rate: The lower the interest rate, the lower the monthly repayment.
- The amount borrowed: The lower the amount borrowed, the lower the monthly repayment
- The Balloon payment/residual value: The higher the balloon payment, the lower the monthly repayment.
A balloon payment is a portion of the purchase price of the car that the financial institution will allow you to pay off at the end of your loan term. In other words, you do not have to repay any capital on this amount as part of your repayments. Now before you think that the bank is doing you a favour, bear in mind that your monthly repayment will still include interest on the full residual value. The bank is only allowing you to pay back a large chunk of the capital at the end of the term because they know that the car should still be worth something. Many people who are buying cars that they can’t afford, will opt for the highest possible balloon payment, and are left owing more than the car is worth. This can start a nasty cycle of rolling balances into your next car purchase and usually catches up with you at some point.
What is clear from all of this is that you should picture all of the variables to the repayment calculation as a sliding scale of sorts. You can play with each one of them: The term, the balloon payment etc to customise your monthly repayment to be exactly what you’d like it to be or what you can afford. This is dangerous because it results in people buying cars that they cannot afford purely because they can afford the repayment.
In previous articles, I have written about using an access bond to finance the purchase of a car. In a way, this allows you to manufacture your own interest rate using another form of finance. The interest rate on your home loan will almost always be preferential to that on your car. If you don’t have an access bond, but you do have equity in your home (Your house is worth more than you owe the bank) you can approach your bank to refinance your home and use the money to buy a car. Aside from the interest rate saving, you will also save the monthly admin fee that you typically pay on a car loan (because your home loan admin fee will remain the same). You will also need to weigh up the costs of re-financing (legal costs/admin fees etc).
Most banks also offer something called a “future use facility” on new home loans. When you enter into a home loan agreement, you can ask the bank to register a bond for the full purchase price of the property, even though you may not be taking up a 100% loan. The unused registered amount can be accessed at a future date without the need to register an additional loan amount in the deeds office or pay legal fees/initiation fees.
In his book, Rich Dad Poor Dad, Robert Kiyosaki famously redefined the terms asset and liability. He said that a car is clearly a liability because buying one (even in cash) results in a monthly cash outflow from your pocket (fuel, insurance, maintenance etc). Try to think of this next time you buy a car. Try not to walk into the dealership with an amount that you can afford to pay monthly in your head – because that would mean that all cars are theoretically within your reach. Understand that a large portion of what you are repaying when financing a vehicle is interest and that your car may not be worth enough in the end to cover the balloon payment. It is easy to be swayed by sales tactics, limited time offers and the sorts. You should buy and finance a car in a way that works well for your financial circumstances as a whole.
- Dean Gerber is a CA (SA) who works in Sales. He can be contacted at: [email protected]
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