And why it’s more expensive than you think
It’s no secret that car dealerships make a profit. However, the amount they make might surprise some people, and saving money by avoiding dealerships could benefit you. This post discusses the dealership’s math and profitability and what you can do to avoid paying too much and ruining your credit. Spoiler alert: Financing a car doesn’t help your credit as much as they say it will.
Dealership cost and profit
Dealerships make money by selling used vehicles at around double their cost. Our following example is a simplified model that can vary based on market conditions, location, and the vehicle’s rarity.
In our examples, we will compare the same car that would be sold privately or at a dealership
- $7,500 privately without a dealership
- $5,000 is what the dealership would pay as a trade or purchase
- $10,000 is what the dealership would sell it for
- $5,000 is what a financing company might make using current average rates
The chart (Dealership V Private Costs) compares the total cost of buying privately to dealership financing. However, the chart doesn’t tell the whole story. For example, halfway through the loan, the buyer will still owe more than the vehicle is worth. This is due to depreciation and compound interest.
Depreciation is the loss of value as time goes on. If the value drops around 15% each year, the vehicle in the example above would look like this:
7,500 x 85% = 6,375
6,375 x 85% = 5,419
5,419 x 85% = 4,606
4,606 x 85% = 3,915
3,915 x 85% = 3,327
You’ll notice it loses 15% of its CURRENT value each year, not 15% of its NEW value. This means the depreciation value is lower each year. This is because some models depreciate slower than others. All new vehicles lose a substantial amount in the first year, usually 30% or so, depending on the model’s purchase price, location and market conditions. We’ve extended the graph to show how the slope flattens. See our Depreciation post for more details.
Dealerships, like most lenders, use compound interest to make more money with financing. In this case, we are using the current average interest rate for vehicles in Canada: 7.66%. While this number may sound small, the total amount you would pay over five years on a $10,000 loan is closer to $5,000 because of compounding. 7.66% per year, over 26 biweekly payments per year (7.66%/26=.295%). Each biweekly payment calculates your total amount owing (balance) multiplied by your rate (.295%), and whatever is left over goes towards paying the debt down (principal). Simply put, you are paying interest on the same amount owing year after year for the amount you haven’t paid off yet. So early in the 5-year term, most of your money will be going towards interest and will be paying most of the loan off later in the loan.
Private Sale value V. Trade-in wholesale value
The amount a dealership would be willing to buy the vehicle or trade is about 2/3 of the private value, shown in the RED line below. The GREEN line represents the total equity in the vehicle over time. (Vehicle value – Amount owed). During the first four years of owning a vehicle, you will owe more than the car is worth. If you wanted to trade it in, you would have the remaining balance (the gap between the green and black lines) owing. In this example, we found that the average rate is 7.66% on Stats Canada.
If we compared the trade-in value to a private sale value, we would see that the equity goes above zero sooner, at 3.3 years. This means that at any time after this point, the sale value could pay off the amount owing on the debt, and the cash to the seller would be the gap between the BLACK line and the BLUE.
The Trade-in Trap
If you wanted to upgrade or change your vehicle, a dealership would sell you a different one and buy your old vehicle as a trade-in. They would take the amount owing between the GREEN line and the BLACK and add it to the financing on the next vehicle.
This chart shows what it would look like if you made it to the end of the 5-year term. If you wanted to trade it in halfway through and did it twice, it would look like this. The trick dealerships use is : instead of offering the same rate (7.66% in this case) over five years, you might be paying a higher interest rate over a longer term because you will owe substantially more than the vehicle is worth. You can see on the GREEN line that the equity never builds even when payments are made.
Get the Most Value From Your Vehicle
If you are already financing a vehicle and want to replace it with another vehicle of similar value, consider completing the 5-year term and saving the payment amounts until you can purchase a different one at the private party value. The BLUE line compares the vehicle’s private sale value over seven years and adds debt (or cash). After seven years, there will be enough cash and vehicle value to purchase a $7,500 vehicle with an extra 1,000 for an inspection and minor repairs if needed.
*This post uses pricing, interest rates and formulas based on reported historical averages and does not reflect current market conditions post-Covid. Variations include, but aren’t limited to, prevailing interest rates, creditworthiness, location, or rarity of a specific model. It is simplified for instructional purposes.
If you find yourself in a difficult or unique situation with a vehicle you are financing and looking for options, call us, we can help. 780-488-3328