You may have heard about depreciation as part of businesses and taxation. It is helpful to use the concept of depreciation in your personal budgeting. Depreciation is the difference in what something is worth today, and what it would be worth in the future. The depreciation is effectively the product loses some value (like a laptop being worth less this year, than it was last year) in exchange for you getting some value out of it by using it (using the laptop).
For example, your car is worth less today, than it was worth a year ago. The difference in value between the value today, and the value of the car a year ago, is called the depreciation. In essence, the cost of using your car during the last year, is the depreciation in addition to the running costs. Many people mistakenly think the loan repayment is the cost, but in reality it is not. If you needed to sell the car a week after purchasing it new off the lot, then you probably won’t get enough money to repay the loan balance. The true cost after a week of owning a car is far more than the loan repayment. Car depreciation is at least 10% – 20% driving off the lot, but the loan repayment may only be a fraction of this cost. If you bought a car for $30,000, and needed to sell the car a week later, it is only worth $24,000. In this case, your depreciation is $6,000 in that first week..
Value Items as Depreciation + Maintenance Cost
This means valuing everything you purchase in relation to both its underlying value, and what it can be sold for in 1 month, 1 year, 5 years.
Let’s look at some examples;
Brioni Men’s Suit vs 10-Year-Old Hyundai Elantra Car for $5,000
You have $5,000 to spend. You could buy;
Both cost $5,000, so the cost feels the same. let’s see the impact on your finances. After 1 month, if you really need to sell;
- The car will re-sell for close to $5,000. Especially if you found a decent deal. The depreciation on the car will be likely just the taxes your state charged on the purchase. We will say a $500 cost (this will vary by state).
- The suit will re-sell for roughly $200 – $400. The depreciation cost of the suit after 1 month is $4,600.
After 12 months the depreciation cost of each item is;
- The car would re-sell for $4,000. An 11-year-old car is not much different in value to a 10-year-old car. Therefore, the cost of the Elantra over the 12 months is $1000 depreciation + $800 insurance + $500 sales tax on purchase = $2,300.
- The suit would sell after a year for roughly the same price $200- $400 as after 1 month. Therefore, the suit deprecation cost is $4,600 – $4,800.
You can see from the examples above, a Brioni Suit in the first year costs your net worth by $2,300 – $2,500 more than the Hyundai Elantra does. Even though both cost the same $5,000.
2016 BMW 7 Series vs Investment Property for $85,000
A car vs investment property example is so obvious; it is almost silly to spell out. Investment property will always be better than a car as an investment. If both cost $85,000, then
After 1 month;
- The BMW 7 Series will fall to about $75,000. The sales taxes/registration will be approximately $8,500, and insurance approximately $200. Therefore, the cost in the first month is $18,700.
- The investment property closing costs will be approximately $4,000 depending on the location. The value will remain the same. A Midwest $85,000 apartment in a B Class area will rent for approximately $1,000 per month with $500 a month expenses. Therefore, the cost in the first month will be $4,000 – $1000 + $500 = $3,500.
After 1 year;
- The BMW 7 Series loses approximately $25,000 deprecation cost in the first year. Insurance of $2,400 for the year + the sales/registration of $8500 = $35,900 cost in first year.
- A Midwest investment property will increase in value approximately 1% – 5% a year. We will therefore be conservative and assume $850 capital appreciation. The rent income after expenses would be $6,000. Therefore, the cost after a year is $4,000 closing costs – $12,000 rental income + $6,000 expenses = -$2,000 depreciation. ie $2,000 appreciation.
After 1 year, the investment property made you $37,900 richer than the BMW 7 Series after a year.
After 5 years;
- A 5-year-old BMW 7 Series will have cost approximately $12,000 in insurance, and now be worth $25,000. So the cost over the 5 years is $70,500.
- The Midwest investment property will likely average 2% per year over a 5-year period, so is now worth $93,850. Assuming no rent increases to be conservative, then the rents will be $60,000 over the 5 years, with $30,000 expenses. Adding back the $4,000 closing costs, the Midwest investment property has earned $34,850 above the initial $85,000 investment.
After 5 years, the investment property has increased net worth by $105,350.
Now that we understand how to value items in depreciation terms, it is possible to “beat the market” on many items to save on depreciation cost. Examples include
- Use outlet malls or discount sales if you want designer clothes. Often they are up to 80% cheaper than retail cost. If that Brioni suit only costs $2,000, then the cost in the first year is $1,600, rather than $4,600.
- Use deal websites like slickdeals.net and purchasing refurbished products online to save money on purchase. This significantly reduces the depreciation period.
- Buy used cars by paying a someone with a dealer license to go to a dealer auction. Dealers advertise this service on sites like craigslist for $500. You get a car for thousands cheaper, as you are getting wholesale prices at auction. If you purchase a car at wholesale, you can often sell it 2 years later for what you paid, giving you an almost free car for 2 years. Then repeat.
Calculate Depreciation for Year
We all know that you should about earning more than you spend each year, but what about earning more than your depreciation? When a business does it taxes to work out how much it made for the year, the business will incorporate depreciation of everything it owns. As an individual, you don’t need to work out your depreciation to lodge your taxes, but it is a good idea to calculate your depreciation for the year, in order to work out if you truly saved more than you “spent”.
A. You can look at what you spent all year.
- Take anything spent on a service (utilities, flights, etc), and the entire amount spent is a cost for the year.
- Now look at what you spent on goods, and calculate roughly what you could sell those items for second hand today. Ebay will give you a good idea on how much items will sell for, and you already know what you paid for items. Be fair on how much you can sell any item for (you are cheating yourself if you think that new car only lost 10% of its value).
B. Look at what you already owned at the beginning of the year, and how much it depreciated.
- Roughly calculate what items were worth at the beginning of the year, and what they are worth at the end of the year.
- Also include anything you did own at the beginning of the year, but didn’t make the end of the year (clothing that was ruined, phone that broke, etc). These depreciated 100% of whatever they were worth at the beginning of the year.
Add A and B totals together to view how much you spent for the year
- Work out how this cost compares to your income. Hopefully it is far more, but if not, you now know you did not make any money this year, and you can start planning how to change that fact next year.
How Understanding Depreciation Can Impact Your Behavior.
Now that you understand the true cost of any physical product is over time (ie the depreciation), this can help you make better purchasing decisions. When deciding to buy a pair of designer jeans for $200, or a tablet for $200, you can think about how much you can dispose the item for when you may not want it anymore. Quick tip, if you think you will get sick of the item after 6 months, the tablet will depreciate less, after 2 years, the jeans may have depreciated less.
Slightly used or refurbished items can be viewed as much cheaper since most depreciation of products occurs between new, and not new (even if that period is a day).
Understanding depreciation can finally motivate you to liquidate any old junk you have lying around, rather than letting it depreciate further, costing you money! Use eBay and Craigslist to dispose of any items of value you have laying around. It will save you money next year!