How They Decide Your Car's Residual Value

When you buy a new car, it's fairly easy to research the costs involved, such as MSRP, local taxes, and delivery charges. We know, however, that the moment a car leaves the dealer's lot, it starts to lose value. But how is that math figured, anyway?

The amount you'll get when you trade in your car, the amount you'll have to put down on your next purchase/lease, and even the interest rate you can get on your next car loan are all impacted by the term you'll hear a lot: "residual value," which is synonymous with resale value. If you don't know the ins and outs of residual value, you're hurting yourself when it comes to buying a new or used car. All cars (except vintage collectables) lose money over time (think of a used car the same way as any used appliance?its worthwhile life expectancy is reduced with age). But buying cars that hold their value better than others isn't hard to figure out, and it's a good way to hedge against the costs of owning a vehicle.

The Basics

There's no hard and fast consensus on the value of a car after a year or five years from its first sale. There are just too many variables at play, including the market for the car, whether the economy is up or down, and the price of gas. Plus, if there are 40,000 used 2009 Accords on the market, each one will have been driven and cared for differently.

But there are variables that can be benchmarked, such as an automaker's and a model's past performance in keeping value, that organizations like Black Book use to estimate what a new car will be worth a few years down the line. Black Book is a lot like the so-called "Blue Book" you hear quoted regarding the value of a car, but Black Book is the go-to that most car dealers use to price a new or used car. It also helps them know what interest rates you'll be charged on a loan.

We talked to Black Book's Ricky Beggs, in charge of the publication's research department, to get an idea of how they figure out what a 2013 model will be worth in 2018.

How Carmakers Keep Car Values High

Supply and demand plays a big role in the value of a particular model in a particular year. Too much "car," just like too much of any single commodity, will depress the value of a car over its life cycle.

Put another way, you might think Mercedes wants to sell as many C-Classes as it possibly can. And if demand were always bullish, that would be true. But Mercedes, just like Honda and every other carmaker, has a vested interest in keeping residual values high because enables Mercedes to have a "cheap" money supply: How much interest they're charged through their captive finance arm (a bank whose sole job is to finance car loans for a single carmaker) directly influences whether they can offer you that nifty 0.9 percent financing deal. High residual values also mean that the certified-pre-owned (CPO) program Benz dealers run can continue to be highly lucrative. A flood of C-Classes two years from now would depress that CPO market. Carmakers try carefully to match production to demand because otherwise they have to crank up incentives (cash back offers) to generate sales, and that's just the type of thing that led to GM and Chrysler falling into crisis. Eventually the "cheap" money spigot shuts off and the debt must be repaid.

So carmakers are smarter than ever at predicting sales volumes and will restrict production if they see storm clouds ahead. Today the cost of used cars is at or near an all-time high because carmakers cut supply during the recession, and because people started holding on to old cars instead of getting new ones. Add in a variable like high gas prices, and in the past five years we've seen crazy things happen, like the value of a used Prius top that of a new one and diesel VW Jettas commanding nearly new-Jetta pricing.

And all of it has to do with carmakers being very careful with supply.

The Fuzzy Math of Leasing

Ricky Beggs of Black Book explains that high residual value not only favors frequent buyers and sellers (or leasers), it also favors the dealer.

Let's consider Mercedes again. Benz is fighting for prestige in the luxury marketplace, and that means the company would prefer a tighter supply. So, for instance, Mercedes might offer its dealers an incentive to buy back current lease-holders' cars a few months early and give them the same lease rate on next year's model, especially at the start of a new model life cycle. This has two effects. One, it tightens supply of that new model, in effect goosing demand so that new customers have to pay a little more. Two, it increases the stocks of CPO cars the dealer has on hand.

But doesn't that second factor depress the marketplace, since there are most pre-owned car sitting around? Not quite. That lease-buyback car the dealer gets on his lot a little early when he puts the customer in a brand-new C-Class increases the dealer's cash flow. He sells a lease on a brand-new C-Class, presumably with money down. And that tightened supply means the "value" of that car is probably higher, too, so the check the dealer gets from the bank/finance arm is fatter. As for the leased car that's now a couple of years old: Ot comes off lease goes into the CPO program, and the bank probably pays the dealer for its remaining value (since most customers finance their cars and pay back the bank over time).

Remember: Either the dealer or the bank (usually a captive finance arm) actually owned the car while the customer leased and drove it. If the bank owns the car, they sell it back to the dealer or to another dealer and pay back that difference to themselves once the car comes off lease. If the dealer holds the paperwork they pay the bank back for the difference and move the car through their CPO program, paying themselves back.

Either way, the lessee is just making a monthly payment on the projected depreciation of that car, plus interest. And don't forget that all those hidden fees and interest from the customer pad everyone's bottom line.

All of this means that leasing is a lot like renting an apartment. You're always putting your dough into the landlord's pocket, paying for the privilege of using an apartment (or a car) but never owning any of it. But if you either can't afford to buy, or want to live in a classier pad (or in this case, drive a classier ride) than you can otherwise manage, renting/leasing makes that possible. Leasing a car that'll hold a higher resale/residual value softens the blow of that monthly payment. The bank and the dealership can give you a better deal if the car is going to lose comparatively little value while you lease it.

We're wading into some quirks of finance here. But it's worth noting that even if you never lease or buy used, this part of the marketplace determines how much a company can charge us for its new cars.

Source: http://www.popularmechanics.com/cars/how-to/repair/how-they-decide-your-cars-residual-value?src=rss

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