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Explain Why Making Payments on a Car Is Such a Poor Financial Decision?
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Karla Franks
Dec 19, 2023, 9:08:11 AM12/19/23
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Financing a vehicle purchase through an auto loan is a routine practice for many consumers in the United States. However, the structure of these loans and the way new cars rapidly depreciate in value means this decision often ends up costing significantly more than the vehicle is worth over the life of the loan. This guide will explore the various downsides of taking on long-term auto debt so readers can make more informed choices about transportation spending.
How Auto Financing Typically Works
The majority of new car purchases involve some form of financing through an auto loan, with terms that commonly stretch between 3-6 years. Interest rates on these loans range dramatically based on a buyer's credit history and score. Rates as low as 0-3% may be available to those with excellent credit, while subprime borrowers sometimes pay 15-20% or higher annual rates after factoring in various fees.
https://www.linkedin.com/pulse/best-5-easy-installment-loans-california-online-same-day-amy-welch-d2jgf
https://www.linkedin.com/pulse/top-5-installment-loans-online-texas-credit-check-quick-amy-welch-j2bwf
https://www.linkedin.com/pulse/best-installment-loans-online-florida-bad-credit-700-1-hour-welch-tdjgf
Loans are structured so the monthly payment amount stays roughly constant throughout the term. However, the majority of each payment in the early years goes to interest charges rather than paying down the principal balance. As a result, the buyer remains "upside down" on the loan, owing more than the vehicle is currently worth, for several years.
The average new car loan amount according to Experian data is over $30,000 with a repayment period of 67 months. This equates to a monthly payment north of $500, constituting a major recurring expense for many household budgets.
Depreciation Drastically Reduces Vehicle Value
One of the most significant drawbacks of financing a new vehicle long-term is how much the car loses in market value immediately after the purchase. According to Kelley Blue Book valuations, the moment a new car leaves the dealership it loses 10-20% of its worth due to being classified as used.
Within just the first year of ownership, the average new car depreciates by around 20% of its original price. After three years, depreciation typically eats up around 40% of the car's purchase cost. By the five-year mark, many new vehicles have retained only 30-40% of their original value.
This means that even if a buyer manages to pay off the entire loan balance by the maturity date, the car itself is likely worth thousands less than what was paid over the life of the financing term due to normal depreciation patterns. Consumers end up sinking more funds into the vehicle than it is realistically worth on the used car market.
High Interest Charges Drain Savings
In addition to depreciation, the interest included on auto loans significantly inflates the total cost. While advertised rates under 3-4% may seem reasonable, the average new car loan APR today is over 9% according to Federal Reserve data. Subprime borrowers can face rates upwards of 15-20% or more after factoring in additional fees.
Interest charges alone on a 5-year, $30,000 loan at 5% would add $5,200 to the balance over the term. Even at the lower end of 4%, over $4,000 in interest is paid. This negates many of the supposed "savings" from manufacturer incentives or financing promotions. Consumers would benefit more from using extra funds to pay down high-interest debt early or investing for future financial goals.
Hidden Expenses Continue After Purchase
On top of the loan payment, taxes, tags, and insurance are necessary ongoing ownership costs that are rarely considered part of the monthly budget impact. Comprehensive insurance for a newer vehicle averages over $100/month nationwide according to Insurify data. Proper maintenance like oil changes and tire rotations should be budgeted at 10 cents per mile or more, equating to $1,500 annually for a driver with a 15,000 mile yearly average.
Repairs for items not covered by extended warranties also introduce financial uncertainty. The average annual cost of maintaining a 5-to-10-year-old vehicle according to AAA is $1,077 not including repairs from accidents or wear and tear issues. Multiplying all these additional hidden fees by 5-6 years of financing payments reveals how much more than the base loan amount is truly spent keeping a new car on the road.
Opportunity Cost of Capital Tied Up
One often overlooked downside of long auto loan terms is the opportunity cost of having thousands of dollars committed to a depreciating asset monthly rather than investments. Even conservatively, money put into the stock market or other long-term holdings could see average annual returns of 5-7% compounded over decades.
For example, a 30-year-old putting just an extra $300 monthly normally spent on payments into an S&P 500 index fund would accumulate over $350,000 by the traditional retirement age of 67 assuming a 7% average yearly gain. The same individual prioritizing a large car payment yields no such return, only sluggish depreciation losses on the vehicle itself.
Used Cars Provide an Affordable Alternative
If transportation needs outweigh budget constraints, a used vehicle remains a more financially prudent choice. For not much more than the down payment on a new car, buyers can obtain a certified pre-owned model under 5 years old and 50,000 miles with a factory-backed warranty after comprehensive inspections. These CPO options depreciate at a slower rate and cost 30-50% less up front.
Even a conventional 3-5 year old car purchased from a private seller avoids the steepest depreciation years and can be fully paid in cash without interest charges. Any needed repairs are still less than the gap between new car pricing and typical depreciation. With modest maintenance, used vehicles reliably meet daily driving demands for most households.
Public Transit and Alternatives Reduce Costs Further
In areas with developed public transportation systems, commuting via bus or rail can eliminate vehicle ownership costs entirely. Ride-sharing apps like Lyft and Uber also provide an on-demand option costing a small fraction of monthly auto expenses for occasional trips.
Car rental services allow borrowing a vehicle for less than a day whenever personal use is needed without long-term obligations. Some cities offer membership programs through companies like Zipcar providing hourly access to nearby cars from just $10. Biking or walking for local errands also saves significantly on fuel and maintenance over time.
With creative planning, a combination of shared and active transit alternatives enables lowering household transportation costs to only a few hundred dollars monthly maximum versus the many financing a new car.
Key Takeaways
New car financing structures are designed to keep loan balances high for years through inflated prices and interest.
Depreciation causes most cars to lose 50% or more of their worth within just 5 years of driving off the lot.
High interest rates on auto loans, often in the high single digits or more, add thousands onto the real cost paid.
Insurance, repairs, taxes, and other ongoing ownership expenses double or triple the true monthly budget impact.
The opportunity cost of tying up funds in an asset that loses value is not recovering potentially larger returns from investments.
Used cars and public/shared transit options provide affordable means of transportation without long-term debt obligations.
FAQ
Q: Won't paying interest help build my credit score?
A: While establishing a payment history does positively impact scores, the amount of interest paid to lenders is not a direct scoring factor. Credit utilization and on-time payments are better focused metrics to periodically report to bureaus through low-balance credit cards or personal loans instead of a high-interest car note.
Q: What if I need a newer, safer vehicle for my family?
A: It's reasonable to prioritize safety, but consider low-mileage certified pre-owned or 3-4 year old options first before pursuing new. Also research manufacturer programs for high discounts on slightly outdated models to compromise affordability with moderate age/features.
Q: Don't car values hold better than depreciation estimates?
A: Most analyses tracking thousands of sales over time have consistently shown 50% value drops within half a decade are the norm. While a few outlier models retain value better, planning finances on exceptions is risky - count on average depreciation curves supplied by industry experts.
Q: How long is a good maximum to finance a car?
A: Most experts recommend terms no longer than 36 months to avoid owing more than the car is worth and minimize total interest paid given constant depreciation. Aim to pay off half the balance within 2 years for best financial positioning.
Q: Are there exceptions where auto financing could work out okay?
A: In rare cases like 0% APR promotional loans under 2 years for a fuel-efficient vehicle kept 10+ years, or if affordable payments fit cleanly into long-term budgets without impacting higher priority goals, auto debt may have less financial downside. But these scenarios are uncommon - used routes are usually better options.
In conclusion, while automobile financing offers convenience, it typically burdens household cash flow and returns through hidden deprecation and interest costs that outweigh any supposed monthly payment benefits. Educating oneself on smarter transportation alternatives can help avoid this pervasive poor financial decision. With creative planning, transportation needs can usually be fulfilled affordably and debt-free.
How Auto Financing Typically Works
The majority of new car purchases involve some form of financing through an auto loan, with terms that commonly stretch between 3-6 years. Interest rates on these loans range dramatically based on a buyer's credit history and score. Rates as low as 0-3% may be available to those with excellent credit, while subprime borrowers sometimes pay 15-20% or higher annual rates after factoring in various fees.
https://www.linkedin.com/pulse/best-5-easy-installment-loans-california-online-same-day-amy-welch-d2jgf
https://www.linkedin.com/pulse/top-5-installment-loans-online-texas-credit-check-quick-amy-welch-j2bwf
https://www.linkedin.com/pulse/best-installment-loans-online-florida-bad-credit-700-1-hour-welch-tdjgf
Loans are structured so the monthly payment amount stays roughly constant throughout the term. However, the majority of each payment in the early years goes to interest charges rather than paying down the principal balance. As a result, the buyer remains "upside down" on the loan, owing more than the vehicle is currently worth, for several years.
The average new car loan amount according to Experian data is over $30,000 with a repayment period of 67 months. This equates to a monthly payment north of $500, constituting a major recurring expense for many household budgets.
Depreciation Drastically Reduces Vehicle Value
One of the most significant drawbacks of financing a new vehicle long-term is how much the car loses in market value immediately after the purchase. According to Kelley Blue Book valuations, the moment a new car leaves the dealership it loses 10-20% of its worth due to being classified as used.
Within just the first year of ownership, the average new car depreciates by around 20% of its original price. After three years, depreciation typically eats up around 40% of the car's purchase cost. By the five-year mark, many new vehicles have retained only 30-40% of their original value.
This means that even if a buyer manages to pay off the entire loan balance by the maturity date, the car itself is likely worth thousands less than what was paid over the life of the financing term due to normal depreciation patterns. Consumers end up sinking more funds into the vehicle than it is realistically worth on the used car market.
High Interest Charges Drain Savings
In addition to depreciation, the interest included on auto loans significantly inflates the total cost. While advertised rates under 3-4% may seem reasonable, the average new car loan APR today is over 9% according to Federal Reserve data. Subprime borrowers can face rates upwards of 15-20% or more after factoring in additional fees.
Interest charges alone on a 5-year, $30,000 loan at 5% would add $5,200 to the balance over the term. Even at the lower end of 4%, over $4,000 in interest is paid. This negates many of the supposed "savings" from manufacturer incentives or financing promotions. Consumers would benefit more from using extra funds to pay down high-interest debt early or investing for future financial goals.
Hidden Expenses Continue After Purchase
On top of the loan payment, taxes, tags, and insurance are necessary ongoing ownership costs that are rarely considered part of the monthly budget impact. Comprehensive insurance for a newer vehicle averages over $100/month nationwide according to Insurify data. Proper maintenance like oil changes and tire rotations should be budgeted at 10 cents per mile or more, equating to $1,500 annually for a driver with a 15,000 mile yearly average.
Repairs for items not covered by extended warranties also introduce financial uncertainty. The average annual cost of maintaining a 5-to-10-year-old vehicle according to AAA is $1,077 not including repairs from accidents or wear and tear issues. Multiplying all these additional hidden fees by 5-6 years of financing payments reveals how much more than the base loan amount is truly spent keeping a new car on the road.
Opportunity Cost of Capital Tied Up
One often overlooked downside of long auto loan terms is the opportunity cost of having thousands of dollars committed to a depreciating asset monthly rather than investments. Even conservatively, money put into the stock market or other long-term holdings could see average annual returns of 5-7% compounded over decades.
For example, a 30-year-old putting just an extra $300 monthly normally spent on payments into an S&P 500 index fund would accumulate over $350,000 by the traditional retirement age of 67 assuming a 7% average yearly gain. The same individual prioritizing a large car payment yields no such return, only sluggish depreciation losses on the vehicle itself.
Used Cars Provide an Affordable Alternative
If transportation needs outweigh budget constraints, a used vehicle remains a more financially prudent choice. For not much more than the down payment on a new car, buyers can obtain a certified pre-owned model under 5 years old and 50,000 miles with a factory-backed warranty after comprehensive inspections. These CPO options depreciate at a slower rate and cost 30-50% less up front.
Even a conventional 3-5 year old car purchased from a private seller avoids the steepest depreciation years and can be fully paid in cash without interest charges. Any needed repairs are still less than the gap between new car pricing and typical depreciation. With modest maintenance, used vehicles reliably meet daily driving demands for most households.
Public Transit and Alternatives Reduce Costs Further
In areas with developed public transportation systems, commuting via bus or rail can eliminate vehicle ownership costs entirely. Ride-sharing apps like Lyft and Uber also provide an on-demand option costing a small fraction of monthly auto expenses for occasional trips.
Car rental services allow borrowing a vehicle for less than a day whenever personal use is needed without long-term obligations. Some cities offer membership programs through companies like Zipcar providing hourly access to nearby cars from just $10. Biking or walking for local errands also saves significantly on fuel and maintenance over time.
With creative planning, a combination of shared and active transit alternatives enables lowering household transportation costs to only a few hundred dollars monthly maximum versus the many financing a new car.
Key Takeaways
New car financing structures are designed to keep loan balances high for years through inflated prices and interest.
Depreciation causes most cars to lose 50% or more of their worth within just 5 years of driving off the lot.
High interest rates on auto loans, often in the high single digits or more, add thousands onto the real cost paid.
Insurance, repairs, taxes, and other ongoing ownership expenses double or triple the true monthly budget impact.
The opportunity cost of tying up funds in an asset that loses value is not recovering potentially larger returns from investments.
Used cars and public/shared transit options provide affordable means of transportation without long-term debt obligations.
FAQ
Q: Won't paying interest help build my credit score?
A: While establishing a payment history does positively impact scores, the amount of interest paid to lenders is not a direct scoring factor. Credit utilization and on-time payments are better focused metrics to periodically report to bureaus through low-balance credit cards or personal loans instead of a high-interest car note.
Q: What if I need a newer, safer vehicle for my family?
A: It's reasonable to prioritize safety, but consider low-mileage certified pre-owned or 3-4 year old options first before pursuing new. Also research manufacturer programs for high discounts on slightly outdated models to compromise affordability with moderate age/features.
Q: Don't car values hold better than depreciation estimates?
A: Most analyses tracking thousands of sales over time have consistently shown 50% value drops within half a decade are the norm. While a few outlier models retain value better, planning finances on exceptions is risky - count on average depreciation curves supplied by industry experts.
Q: How long is a good maximum to finance a car?
A: Most experts recommend terms no longer than 36 months to avoid owing more than the car is worth and minimize total interest paid given constant depreciation. Aim to pay off half the balance within 2 years for best financial positioning.
Q: Are there exceptions where auto financing could work out okay?
A: In rare cases like 0% APR promotional loans under 2 years for a fuel-efficient vehicle kept 10+ years, or if affordable payments fit cleanly into long-term budgets without impacting higher priority goals, auto debt may have less financial downside. But these scenarios are uncommon - used routes are usually better options.
In conclusion, while automobile financing offers convenience, it typically burdens household cash flow and returns through hidden deprecation and interest costs that outweigh any supposed monthly payment benefits. Educating oneself on smarter transportation alternatives can help avoid this pervasive poor financial decision. With creative planning, transportation needs can usually be fulfilled affordably and debt-free.
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