Saturday, February 19, 2011

Budgeting: Part 23: Buy Or Repair Fallacy

"Economics is a very difficult subject. I've compared it to trying to learn how to repair a car when the engine is running."
- Ben Bernanke

(In this post and subsequent posts, I am walking though 12 different examples of household budgeting mistakes and how they can all be corrected with accrual accounting techniques. Accrual accounting recognizes income when it is earned and expenses when they are incurred. An alternate definition is that accrual accounting records events that change your net worth.)

The symptom:
Expensive repairs still seem better than new purchases.

The example:
Your 15 year old car had a cooling problem that permanently damaged the engine. The shop said it would cost $4,000 to replace the engine and the cooling system. That still seems like a bargain compared to spending $20,000 for a new car. Hence, you decided to go ahead with the repairs. Surprisingly, not all your friends think you did the right thing! You don't understand why people can't clearly see that $4,000 is a much better deal than $20,000.

A lot of the recent posts were financing examples of one sort or another. This automobile repair example will be a little different. While you don't really need accrual accounting to work through the problem, it does give another useful perspective on financial decisions.

So let's analyze the car situation. Before the engine damage, how much was the car worth? Since it was 15 years old, it's clearly not worth very much, but I will be generous and say it's worth $1,500. Now how much is it worth after the cooling debacle in its damaged state? This can be debated, based on salvage value, estimated repair costs, and other factors. But the two indisputable facts are: a) It's now worth a lot less than it was before, and b) It can't be worth less than $0 because you can always scrap it and walk away.

Next, let's think about how much the car is worth after the repairs. Well, it's still a 15 year old car in average condition with a lot of miles, but it has a new engine and a new cooling system. So how much is it worth now? Unfortunately, it's not worth a whole lot more than it was worth before ($1,500). Now you might be wondering how you would be expected to know that if you aren't a "car person". But you would probably be able to arrive at the correct facts if you use your intuition.

Suppose you are shopping for a 15 year old car, and you see different cars with prices clustered around $1,500. If one has a new engine, are you going to pay dramatically more for it? No, you won't, although the new engine is certainly a plus. If you're looking at two similar cars that are both $1,500 and one has a new engine, you'll probably go with the new engine. But what if the owner tries to jack the price up due to the new engine. How much more are you really willing to pay given that the rest of the car is the same? Would you pay $5,000 or even $3,000? I doubt it. You might be willing to pay $1,800 or something like that. And this, in fact, turns out to be how the pricing works. If you go to a pricing site and fill out condition details for two hypothetical old cars and hold everything constant except for the mechanical difference between average and good/excellent, you'll see that it only changes the value by a few hundred dollars.

So what does this all mean? Let's keep the math simple by excluding anything not related to the example. Here's what happened:

Start of the example: Net worth = $1,500 (car)

After the breakdown: Net worth = $200 (junk car)

After the repair: Net worth = $1,800 (car) - $4,000 (repair bill) = -$2,200

Wow. That is brutal. The engine failure made you $1,300 poorer, but the repair itself was even worse - fixing it made you $2,400 poorer. That should be telling you that fixing the car is a bad financial decision, which may come as a minor shock to some people.

The reason some people make this mistake is because they focus only on the immediate cash amounts one would have to pay. Since $4,000 in repairs is less than a $20,000 purchase of a new car, it looks like a no-brainer. Such a simplistic comparison, however, ignores the fact that there are complex factors to consider such as the likelihood of future maintenance and depreciation. If you need to make a decision between fixing a car or buying a new one, there are many good resources available, including a comparison article from Edmunds, and a similar article from Bankrate.

Lastly, I would like to point out that the major error most people make in these comparisons is the failure to consider a third option: buying a similar used car. I've known several people that frugally drove an old car for years, but then the minute there was a large repair bill, they either reflexively paid any amount of money to fix it, or they rushed right out to purchase a new car. In most cases, they told me later that they regretted this decision.

If people want to buy a new car, that is their business, but I find it odd when people tell me they bought a new car to "save money" relative to spending gobs of money to repair a really old junk car. Choosing an expensive option over an even more expensive option doesn't really seem to qualify as an extraordinary exercise in frugality. Otherwise, we could justify any expenditure with this logic. "A BMW is cheaper than a Rolls Royce that I could have bought, so I'm saving money. And a 9 bedroom house is cheaper than a 12 bedroom house that I could have bought, so I'm saving money."

The other argument I hear for always repairing the car is that it saves time. You already own the car, it's in the shop, and if you just pay the money, you get a working car back in one or two days and there is nothing else to do. I am actually very sympathetic to this argument because I value my time very highly, but I have to question whether this makes sense in the larger context of your entire life.

Many people spend countless hours chasing small savings. They grow their own vegetables, wash their own cars, run around to yard sales, take alternate driving routes to save tolls, research the cheapest price on small items, and even wash sandwich bags. For all that effort, they may only save a couple of hundred dollars for an entire year, yet they consider it to be time well spent.

Why then do people balk at the opportunity to save $2,400 by finding a similar car to purchase instead of overspending to repair the existing one? Suddenly they are too busy to spend two or three days of part time work to save a large amount of money. "I don't have time to look for a used car on Saturday. I need to mow my lawn and research how to fix the toilet." Really? I believe it would be better to spend $125 on a plumbing call and pay the neighbor boy $25 to mow the grass while you find another $1,500 car to drive instead of paying $4,000 to fix the old one. You were happy with such a car last week, so don't overreact to the situation. Let the net worth numbers guide you to a wise choice.