Showing posts with label autos. Show all posts
Showing posts with label autos. Show all posts

Monday, June 4, 2007

Is your car worth less than $5,000? Consider canning your comprehensive insurance.

Chances are if you are as frugal as the Armchair Fiduciary at some point you will end up driving a car worth less than $5,000. If you find yourself in this position, it might be time to cancel your comprehensive insurance and save yourself a few hundred dollars annually. In case you don't know comprehensive insurance is one of two types of car insurance. Comprehensive car insurance covers non-accident related damages such as hail, vandalism, and theft. Collision insurance is the other kind of insurance and it covers damage to property and people (i.e. medical bills) as a result of an accident. It is generally required by law in the United States.

Before delving too deeply into why one would cancel comprehensive insurance, let's understand the basic concept of insurance. Insurance companies sell policies to individuals to protect them from adverse events. The insurance company, a little like a casino, doesn't mind losing once in a while because they use statistics and the law of large numbers to predict what their losses will be and then they price their policies such that the house will win over the long term.
Individuals buy insurance because they are risk averse (and in the case of auto insurance because they are often required to by law). Risk aversion means that you don't like big negative surprises. For instance, if there is a 1/100th chance that you will lose $99 and there is a 99% chance that you will make $1 the expected value of the situation to you is $0. A risk neutral individual should not care about the outcome because their expected value is $0. A risk averse person might be willing to pay slightly more than $1.00 for insurance to protect against the $99 potential loss. This guarantees a return of slightly less than $0, but also avoids the off chance of a big loss. This may seem irrational at first but lets consider a slightly different situation where the loss is $99,000,000 and there is a a 1/100,000,000th chance of that outcome but the gain is still $1.00 the rest of the time. In this scenario giving up a few pennies might seem like a more rational decision than risking a huge fortune even if the chances of losing it are remote. When the pain of losing a lot of money is a lot more than the benefit of a higher expected value, that is risk aversion.

While insurance companies can spread their risks over thousands of customers, an individual customer only gets one shot and they therefore have a reason to be risk averse, nobody wants to be the one out of 100,000,000 and lose everything just because they are unlucky. Buying insurance helps you avoid “becoming a statistic,” but the insurance company will charge you something for the privilege.

So by now you may understand why getting rid of comprehensive on a cheaper old car may make sense. You can increase your expected return because the insurance company is going to charge you a little more for comprehensive insurance than is statistically fair so that they can make a profit. If losing your car would not bother you that much and you can afford taking a $5,000 risk then you should cancel your comprehensive insurance and just carry the collision/liability insurance required by law. This should yield you several hundred dollars of savings per year and improve your expected value while exposing you to the remote risk of a $5,000 loss if your car was totaled due to vandalism, hail, etc.

Saturday, April 7, 2007

Buying a New Car? Think Again. Used is a Better Value.

I have never owned a new car. I hope I never will. Why? Simply put new cars depreciate too quickly to be a good value. The Saab Weblog has a good example of a typical new car depreciation curve. You will notice that in year one that the depreciation curve is VERY steep. While I like the smell of a new car, the smell of burning dollars more than negates new leather in my opinion.

When I shop for a car I typically try to find one that is 3-4 years old and being sold by a private buyer. The reason to avoid dealers is pretty simple: they mark cars up a lot. A simple look at the difference between private party and dealer prices on the Kelley Blue Book should illustrate this point. While some people feel it is worth the extra money to get a super clean car and have a throat to choke if there is a problem a week or two into driving the vehicle, I think you can still do better with private parties if you take the proper precautions. Cars.com is a great place to start your search for a private party vehicle.

When dealing with a private party I suggest doing the following things: First, pull a Carfax report on the vehicle. Make sure the title is clean (i.e. not a salvage title) and that the car has not been in any major accidents. If there is a problem with either of these things I would move on to the next car; there are plenty of them out there! Second, I would be sure to ask the owners why they are selling the car. If the answer sounds fishy, I would walk away. Third, ask the owners for their mantenance records and how they cared for the car. If they can't produce records or tell you how often the oil was changed or the car was serviced, I'd look elsewhere. If all these things check out, chances are you will come out ok with the car (I have so far).

Should I finance a car? Generally, I'd say the answer is no. Auto loans fall into a category I'd call "bad debt" where the interest is not tax deductible (in most cases) and the item you purchased depreciates. "Good debt" includes mortgages for a home or loans for education -- look for more on these in other posts. Chances are if the only way you can afford a car is to finance it, you shouldn't be buying a car that is so expensive. Whenver you take a loan the finance company tries to extract a fair rate of return from the money they lend to you. That drives up the cost of owning your car. Generally, I would say the same rules apply for leasing. In most cases you will want to avoid it.

So the next time you are in the market for a "new" set of wheels be sure to remember the smell of burning money is stronger than the smell of a new car and buy used with cash.