Understanding car depreciation and making the best car decision

For more information on making a great car buying decision, please see: Cutting through complexity: A confidence-building car buying approach

Typical depreciation curve and market considerations for buying a car.

The used car market is dynamic. For example, the pandemic disruption impacted the traditional shape of the car depreciation curve. This was caused by supply chain disruption and other market forces. Even after disruptions, many car professionals believe the future curves will return to the shape discussed in this article. More importantly, most auto lenders pricing and credit policies assume the traditional depreciation curve shape. Thus, the approach in this article remains consistent with making the best car-buying decision. Especially, since the car buying process involves a prediction of future market forces.

Intuitively, car depreciation makes sense. A car has many moving mechanical parts, faces many risks, becomes obsolete, and suffers regular wear and tear. Unless a car has some unusual investment value, the underlying value of the car must decline as it ages.

The “Here” on the graph is known as the inflection point. This is the point that value deceleration slows to where car values decrease at a decreasing rate. (In math language, this is where the second derivative of the estimated curve is about 1.) This is a good model vintage to consider buying.

Typical drivers of depreciation:

• Actual wear - this also relates to maintenance costs, an expensive-to-maintain car will drop in value faster

• The new car market - a strong new car market may depress demand for used cars

• The used car market - this may relate to 1) seasonal, like the time of year new car trade-ins may enter the used car market, or 2) cyclical, like when leasing residual and used car market imbalance may drive large lease cancellations and autos entering the used car market. Also, in a declining economic cycle, car loan repossessions may create an increase in the used auto supply.

• The salvage value market - may be driven by government programs like “Cash for Clunkers.” Think of salvage value as price support as the car ages.

Upon solving the second derivative across the vintage years (x), the 5th car vintage year is closest to 1. So, target buying a car at least 5 years old to reduce depreciation risk. Our CPRM model is an approach aligned with identifying cars with lower depreciation risk.

You may have noticed - in the picture - the inflection point appears closer to the 7th year. Also, please notice each make has a similar but somewhat different depreciation curve. It is estimated that the car model curve volatility suggests a 2 year confidence interval on the low side. Thus, 5 years is chosen as the “at least” target.

From a practical standpoint, when this car age target is applied using the CPRM framework found in the Cutting through complexity article, the highest value used cars will quickly reveal themselves.

For help making the best car decision, please see this smartphone app:

In case interested, this is how the math works regarding the optimal model year:

The above depreciation curve has the following estimated functional shape formula:

y(hat) = f(x)= -.318 ln (x) + 1.0011

and simplified:

and the second derivative:

Upon solving the second derivative across the vintage years (x), the 5th car vintage year is closest to 1.

Could one attempt to estimate individual depreciation curves for each car model? Sure. With enough data, expertise, and time anything is possible. Actually, auto lender risk management organizations do this to help them understand loss, loss reserving, loan pricing, CCAR requirements, etc. However, for our purposes, this would be overkill! Just knowing the 5th year is generally the car depreciation curve's inflection point provides most of what we need to know about depreciation when buying a car.

Rule of thumb: Consider cars about 5 years old to optimize the remaining value.

This rule of thumb should be considered in the context of the car buying framework.