Explain Why Making Payments on a Car Is Such a Poor Financial Decision?

[Melanie Jones]

While having a reliable vehicle is important for daily transportation needs, committing to lengthy car payments can seriously hinder your long-term financial health and wealth building goals if not done carefully. This comprehensive guide will explore the many hidden costs of auto loans and explain better alternatives for your personal finances.

Upfront Costs of a New Car Loan

The average new car payment in the United States currently sits at around $700 per month according to AAA. Let's consider a typical 60-month, 3% interest auto loan for a $30,000 new vehicle. The total amount paid back over the full term would be over $34,000, with over $4,000 of that being interest charges alone.

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While that $700 monthly payment may seem manageable, you need to account for several other substantial upfront costs on top of the principal and interest. Tax, title, and license fees can easily top $1,000 at purchase. You'll also need comprehensive insurance, which for a new car could be $100-200 per month depending on your driving record and coverage levels. Finally, new cars require routine maintenance and tune-ups that may run a few hundred dollars each year.

In the first year alone, you could pay over $10,000 just to keep a new vehicle on the road between the auto loan, insurance, taxes, fees, and initial maintenance. That's a huge short-term financial obligation to take on for a depreciating asset.

Rapid Depreciation Hurts Resale Value

One factor that makes new cars such a poor long-term investment is how quickly they depreciate in value from the moment you drive off the lot. On average, a new vehicle loses over 20% of its worth in the first year. By year three, it will be worth around half of its original MSRP.

Let's say hypothetically you decide to sell your $30,000 car after three years of payments. With typical 50% depreciation, it would probably only fetch $15,000 on the private resale market. You would be $15,000 underwater on your loan if you still owed the full $30k. The rapid depreciation ends up being dead money that provides no long term return.

Ongoing Expenses Are Substantial

While the primary monthly auto loan payment gets all the attention, it does not incorporate other ongoing vehicle costs over 5-10 years of ownership. Fuel prices fluctuate but on average cars require over $2,000 worth of gasoline annually. Insurance coverage alone could top $100-200 per month.

Maintenance, repairs, and routine part replacements also add up. Even normal wear items like brake pads, tires, and wiper blades will run a few hundred dollars each time they need servicing. Major repairs for issues like transmission replacements or head gasket failures can easily costs thousands.

Over a typical ownership cycle, expect to pay $5,000-10,000 on top of the auto loan principal on fuel, insurance, maintenance, and repairs for the average car. This balloons the long term car budget well above just the monthly payment amount.

Lack of Emergency Fund and Flexibility

Committing several hundred dollars from each paycheck to an auto loan payment leaves very little room for error in your finances. If you face an unexpected mid-month job loss, medical expense, or home repair, you may struggle to still afford that car note along with other daily living costs.

It also prevents growing an adequate 3-6 month emergency fund, which financial experts recommend as best practice. Having cash reserves gives stability to weather hard times without taking on additional debt out of necessity.

Lengthy car loans also reduce flexibility should better financial opportunities arise. Want to go back to school, change careers, or relocate for a new job? You'd face hurdles trying to sell an underwater vehicle or take it with you.

How Affordable is "Affordable"?

Many auto lenders are all too willing to stretch car payments out to 5-7 years at very low monthly rates, ignoring the total cost of ownership and long-term affordability. This expanded loan period may squeeze the payment under 10% of your take-home pay, which is a common affordability guideline used.

However, does a $500/month note really fit your overall budget if you have other debt like student loans? What if the transmission dies in year four - can you afford the repair bill? Committing close to the affordability limit provides little wiggle room for unexpected expenses. Overextending leads to increased financial stress.

Stronger Alternatives Exist

Rather than saddling yourself with lengthy depreciating auto debt, consider options that are less damaging to your long-term budget and net worth:

Pay cash upfront for a reliable used vehicle that meets your needs. This avoids interest charges and gets you into a paid-off asset.

Finance a certified pre-owned or 2-3 year old used car at a lower price with a shorter 36-48 month term loan at lower interest rates than new vehicles.

Consider leasing as an alternative if you want a new car experience but don't want the long-term debt commitment. However, leases also come with mileage limits and fees.

Use public transportation, bike, walk, or carpool when possible to reduce your transportation costs overall.

Drive your current vehicle into the ground before taking on new financing if it's still road worthy. Avoid the emotional temptation of a new vehicle purchase.

Build an emergency fund before any new vehicle acquisition to ensure you can still afford payments if life throws you financial curveballs.

Key Takeaways

In summary, the major downsides of long-term auto financing are:

Rapid depreciation losses

Ballooning total cost of ownership beyond payments

Lack of emergency funds and financial flexibility

Potential overextension of affordability

Purchasing quality used vehicles or alternative transportation can help avoid these pitfalls. Having the vehicle paid off sooner rather than focusing only the low monthly quote makes for a more prudent long-run financial strategy.

FAQs

Q: How can I calculate the total cost of car ownership?

To accurately budget, estimate your annual costs for fuel, insurance, maintenance/repairs, and account for depreciation based on your vehicle/mileage. Total these figures to get the "true" annual cost that goes far beyond a loan quote.

Q: When is leasing a car a better option than buying?

Leasing can work well if you want a new car experience every few years but don't drive excessive miles. It caps your long-term liability and may be cheaper than interest on a loan. However, it does not build equity and has mileage/excess wear and tear penalties.

Q: What length auto loan is considered high risk?

Anything over 5 years starts stretching the affordability limits and runs risks. At 6-7 years, nearly the entire vehicle lifespan is financed rather than owned, and much interest is paid purely for consumption.

Q: How do I calculate my real borrowing costs beyond interest rate?

Factor in all interest paid over the term, plus fees, taxes, and average annual costs like maintenance to see the "fully loaded" multi-year expense of auto financing decisions. This illuminates the true toll on finances beyond just the payment amount.

Q: Should I pay off my car loan early?

If you can afford to pay extra to retire the principal faster without hurting savings goals, it can save thousands in interest costs in the long run. Just ensure to factor in potential prepayment penalties in your loan documents first.