Houses aren't the only things that can be upside down. You can get underwater on a car loan, too -- with disastrous consequences.
If you’re strapped for money, buying a brand-new car is one of the worst financial moves you could make. It’s like throwing money into a deep hole. That’s because, as you probably have heard, a new car starts losing value as soon as you drive it home.
But here’s an even worse move: financing your new car with a seven-year loan.
In the video below, Money Talks News founder Stacy Johnson offers a step-by-step approach to buying your first set of wheels. Take a look, and then keep reading for more details.
Worth less every minute
Unless you’ve got plenty of money, a new-car purchase can ruin your financial stability. On average, Kelley Blue Book says, new cars lose (depreciate) 60 percent of the original purchase price in the first five years. In its first year alone, the average new car loses 36 percent of what you paid for it, according to Kelley.
So, buying new puts you in a losing position immediately. Here’s how it looks in real life. Suppose you bought a new car for $30,000:
- After one year, it’s worth about $19,200 (-36 percent) on average.
- After three years, it’s worth $14,400 (-52 percent) on average.
- After five years, it’s worth $12,000 (-60 percent) on average.
- If you sell the car for $12,000, you’ve taken a $18,000 loss.
In other words, if you paid $30,000 in cash for your new ride, you’ve spent, on average, $3,600 a year over five years just for the privilege of driving it. That doesn’t include your costs for fuel, maintenance, repairs, license and insurance.
Here’s a tip: Most of the depreciation happens in the car’s first two years, Kelley spokeswoman Brenna Robinson says. That makes buying a 2-year-old vehicle a particularly good deal. It’s still new enough to enjoy, but it has lost most of the new-car premium.
Maybe that extra expense is worth it to you. And maybe you can afford it. At least when you pay cash, you’re not upside down, meaning that you owe more on the car than it’s worth.
But how many buyers pay cash for their $30,000 cars? The chances are good you’ll have to finance it. That’s where the real problems can begin. You’ve heard about underwater mortgages? Upside down, underwater — it’s all the same thing. You’re upside down when you owe more on your vehicle or home than you can sell it for.
Damage to your bottom line
Here’s a look at how a long-term loan can damage your bottom line: When you finance a purchase, unless you make a big down payment, your costs increase considerably, because now you’re paying interest on top of the purchase price.
Suppose your credit score is 600. According to Money Talks News’ credit union auto loan search, if you live in the San Francisco Bay area, for example, you can expect to be offered loan rates ranging from 6.99 to 14.99 percent APR.
A growing number of vehicle buyers are borrowing more and stretching out their car loans as long as possible. This lets you buy a more expensive vehicle and still keep the payments within your budget. Sounds like a good idea – at first. But stay tuned.
If you borrow at 15 percent and stretch your payments over seven years, not unheard of today, here’s what you’d owe, on average, on a $30,000 car:
- After one year, the vehicle’s value is $19,200, and your loan balance is $27,141.
- After three years, the vehicle’s value is $14,400, and your loan balance is $20,482.
- After five years, the vehicle’s value is $12,000, and your loan balance is $11,509.
Paying $48,628 for a $30,000 car
You’re upside down on your car loan. You owe more than the vehicle is worth.
Do your own calculations using Bankrate.com’s auto loan calculator:
- Plug in your numbers and click on “calculate” to see your monthly payment amount.
- Scroll down (skip the “extra payments” section) and click on “Show/Recalculate Amortization Table.” This table shows every payment you’ll make for seven years, how much of each payment goes to pay off interest and how much goes to the principal (your equity, or your ownership share in the car).
- On the very last line is the total interest you’ll pay: $18,628. That means you’ll have paid a grand total of $48,628 for your $30,000 car.
In the first years of the loan, most of your monthly payment goes to pay your lender interest on the loan. As years progress, increasingly more of each payment goes to paying off principal.
You can see why auto financing companies want you to trade in your old car and buy a new one every few years. They make huge piles of money on the loan interest in the first few years and increasingly less after that. For them, it’s better if you keep taking out new loans than if you hang on to your old loan.
Your very own sinkhole
Being upside down on your auto loan can tip you into a financial sinkhole:
- If you’re in a wreck and the vehicle is totaled, or if it’s stolen, insurance won’t pay off your loan. You could end up making payments on a vehicle you no longer can drive.
- You may still owe money on the vehicle when you want to sell or trade it in. Depending on your financial situation, a bank or auto lender may not give you a loan on another car if you are still paying off the old one.
- A longer-term loan means your vehicle has more mileage by the time you own it free and clear. You’ll get less for selling it or trading it in. This leaves you with less for a down payment on the next vehicle, forcing you to borrow more if you keep buying high-end vehicles. It’s a vicious cycle, leaving you poorer with each purchase.
Have you ever been underwater on an auto loan? Share your experience below or on our Facebook page.