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Car depreciation and residuals explained

How often have you heard it said that something is worth only what somebody is prepared to pay for it? It’s an undeniable fact and it’s true of anything whether it’s a painting, a piece of jewellery or a car.

What underpins the value of something is the balance of supply and demand; if there’s lots of demand but not much supply, values will be high. But if you reverse the situation and there’s an oversupply, values will be low. This is how the car market works, but there’s an added complication because sometimes there’s strong demand and ample supply too.

When you buy something new it loses value as soon as you take possession. It has to be worth less than what you paid for it, because it’s used. After all, why would someone pay the same for a used item as a new one? In the world of cars there are a few examples that buck the trend, but they’re few and far between.

For example, limited-production cars such as some Ferraris will always sell for more than list price – there’s a huge demand but hardly any supply. It’s the same when a new luxury car is introduced; when the first Bugatti Chirons or Ferrari LaFerrari Spyders are delivered, wealthy collectors will pay a hefty premium over list price to be one of the first to take delivery. But those cars will be listed at over £1 million apiece…

For those of us who use our cars as everyday transport, we have to put up with the phenomenon that is depreciation. The problem is, because cars start out being relatively valuable, they can shed a lot of value as they get older – and it’s this loss of value (depreciation) that is the biggest cost of running a car. Most owners think only about road tax and fuel costs, along with maybe insurance and servicing; depreciation is the hidden cost of running a car.

The depreciation curve

Cars lose value at varying rates, but in most cases they follow an exponential curve – that is, it levels out over time. So in the first year a car might lose 30% of its value then another 20% in the second year. By the end of year three it’s probably lost another 10%, so 60% after three years.

While the rate of depreciation has slowed, what matters is that your car is worth just 40% of what you paid for it three years earlier. If you paid £40,000 for it, that means its value has dropped by £24,000 in 36 months. At £8000 per year, that loss in value could easily outstrip the fuel, road tax, insurance and servicing costs.

As buyers have got used to keeping their cars for shorter periods, the new-car market is more buoyant than ever. Last year a record 2.6 million new cars were sold in the UK. In a country with just 31.8 million licence holders, that means one in 12 drivers bought a new car in 2015. Some of those cars will be kept until they fall apart but many owners will repeat the process after just a few years, even though their cars will still have plenty of life left in them.

As a result, there’s oversupply of most mainstream cars including some that are perceived as being rather exclusive. Years ago, premium brands such as Mercedes and BMW sold relatively few cars. But now everybody is chasing volume so there are huge numbers of all types of car around. The problem is that because these cars cost so much to buy in the first place, they have further to fall.

Admittedly a BMW or Mercedes tends to lose value at a slower rate than a Ford or Vauxhall, but the cash difference isn’t always as much as you might think. For example, a BMW 3-Series might lose 30% of its £30,000 value after two years while a Ford Mondeo might lose 40% of its £24,000 value in the same period.

For the Ford this represents a £9600 loss, and £9000 for the BMW, but with a decent discount on the Mondeo easier to come by, you could easily find that the German car loses the most value in cash terms. It all comes down to what sort of a deal you can get on that new car.

New vs used

If you’re buying new you want a car to retain as much value as possible, so you have some extra equity when you come to sell it. But if you’re buying used you’re better off going for something that’s lost more of its value, so it’s cheaper. Or are you?

The fact is, the rate at which cars depreciate is largely down to how desirable they are; if nobody wants them, they’re worth very little – but they can be unloved for a variety of reasons. Key factors that affect how quickly a car depreciates include:

  • The mileage: buyers don’t like high-mileage cars, so as the mileage goes up, so does the rate at which the value drops.
  • Number of owners: buyers like one-owner cars. As this number goes up, so can the rate of depreciation.
  • The general condition: tired paint, dents and stained interior trim suggest neglect; used car buyers want something that’s been cherished.
  • Service history: if you can show that a car has been maintained properly it’ll be worth that much more.
  • Road tax band: buyers are more focused than ever on cars that cost no more than £30 per year to tax.
  • Fuel economy: high fuel prices have focused buyers’ minds. They don’t want to pay more for fuel than they have to.
  • The car’s size: Big cars cost more to run than smaller ones so they tend to depreciate more heavily.

The one that isn’t on the list is image, and it’s this that can make the biggest difference to a car’s value. If a car is largely invisible through a lack of marketing, there’ll be little demand for it. Similarly, if a car is uninspiring but easy to own it’ll probably have received poor reviews in the motoring press, and it’s these models that can be the greatest bargains.

* If you’re in the market for a used car, don’t buy anything without first reading our used car buyer’s guide. It tells you everything you need to know about buying a used car for the ultimate in peace of mind.

Richard Dredge

June 2016