Outside of a few major cities, cars are the main form of transportation for the majority of the country. The car we choose and how we pay for it, however, can make a world of difference financially. According to the Federal Reserve Bank of New York, 107 million Americans had car loan debt in 2017. That’s about 43% of the US adult population. That is absurd! Although getting a car loan makes sense in some situations, it’s usually a bad idea.
Is a car loan good debt?
A car is often a necessity, but the cost of ownership can be significant. Taking out a car loan can help you afford the vehicle you need, but it’s important to understand the pros and cons before you borrow.
When a car loan is good debt
1. Improved credit score: Making on-time payments on a car loan can help improve your credit score, which can lead to lower interest rates on future loans, such as a mortgage or personal loan.
2. Access to a reliable vehicle: A car loan can help you afford a reliable vehicle that can get you to work, school, or other important destinations. This can be especially important if you live in an area where public transportation is limited.
3 Lower monthly payments: A car loan can help you spread out the cost of a car over several years, making the monthly payments more affordable. This can free up your cash flow for other expenses
When a car loan is bad debt
1. High interest rates: Car loans can have high interest rates, especially if you have bad credit. This means you’ll end up paying more for the car than it’s worth.
2. Long repayment terms: Car loans can have long repayment terms, which means you’ll be making payments for several years. This can tie up your money and make it difficult to save for other goals.
3. Risk of default: If you can’t afford to make your car payments, you risk defaulting on the loan. This can damage your credit score and make it difficult to borrow money in the future.
Alternatives to car loans
1. Save up for a car: If you can, it’s best to save up for a car in cash. This will avoid the interest payments and other costs associated with a loan.
2. Buy a used car: Used cars are typically much cheaper than new cars, and they can be a good option if you’re on a tight budget.
3. Lease a car: Leasing a car can be a good option if you don’t want to deal with the hassle of selling a car when you’re done with it. However, leases can be more expensive than buying a car, and you won’t own the car at the end of the lease term.
The bottom line
A car loan can be a good debt or a bad debt, depending on your circumstances. If you can afford the monthly payments and you’re using the car for work or other essential purposes, then a car loan can be a good way to finance your purchase. However, if you can’t afford the payments or you’re using the car for non-essential purposes, then a car loan can be a bad debt.
Additional resources
- Bankrate: When to Avoid Auto Loan Debt & When It Makes Sense
- The Money Speakeasy: 5 Reasons Car Loans Are A Bad Deal
Disclaimer
I am an AI chatbot and cannot provide financial advice. The information provided above should not be considered financial advice. Please consult with a qualified financial advisor before making any financial decisions.
Why Car Loans Are A Bad Deal
Most people don’t understand how costly depreciation is. Depreciation just a fancy way of saying that something is losing value over time. Depreciation for cars is steep. As an illustration, the average cost of a new car is approximately $30,000. However, the moment you drive it off the lot, when the odometer reaches 200, the car loses 10% of its value. Imagine withdrawing $3,000 in cash and bank deposits, laying out 300 Benjamins on the ground, covering it with gas, and setting it on fire. Some people love the new car smell, to me, it smells like burnt money. Click To Tweet Now that was just the first minute. The average car loses roughly 20%25 percent of its value in the first year and almost 2050 percent in the first three years of ownership. So that $30K car is worth about $15K three years later. Although the rates at which cars depreciate vary, the general rule is that borrowing money to purchase a depreciating asset is almost never a good idea. Imagine you were at the store and you saw a $100 item you wanted, but it was the last one and the box was broken. Even though the box was damaged, you thought it was still good and wanted to buy it. Typically, they would take 10% off because the box was damaged and offered it to you for $90. What would you think if I told you that you really paid $110 for that depreciating asset instead of just $90? When you borrow money, there’s a cost (interest). As a result, in addition to paying the car’s retail price, you’re also making interest payments while its value is dropping quickly.
Knowing about depreciation, you can see why taking out a long-term loan is not a good idea. The average car loan in the US is now over 69 months, that’s nearly 7 years. You will pay more interest and have a higher chance of being upside down on your loan—that is, having more debt than the car is worth—the longer the loan for a car. Trust me, you do NOT want to be upside down on a car loan. That is truly the sunken place. Although I detest auto loans in general, you really can’t afford one if you can’t afford to pay it off in three years.
It’s also a credit risk to have car loans. Within a 5-year span, it’s very likely that you’re going to have at least one major financial emergency. It could be a job loss, a health emergency, home repairs, car repairs or even a combination. If you’ve ever found yourself in a predicament where you have little money due to an emergency, having a large monthly auto payment is the last thing you want. It makes dealing with a financial emergency much more difficult. There is a greater chance that you will harm your credit by missing or being late on payments when you are in a financial bind during those emergency situations. One missed or late payment can affect your credit for 7 years.
The truth is car loans are killing wealth. We have somehow normalized going from car loan to car loan. That’s a recipe for staying broke. The average car payment today is $523/month. Over 30 years, that’s $188,280 worth of car payments. Imagine if we invested it instead. $523/mo. invested over 30 years is $611,624 with a 7% annual return. So you can either give $188K away to banks and car companies or earn yourself $611K. You choose.
For many, driving to and from work accounts for the majority of their mileage and the main use of their vehicle. Think about how insane it is to pay over $6000 a year just to get to work. On an average income of $50K, that’s 12-15% of your income before you even start working. To really blow your mind, figure out how many hours you would have to work to pay your car payment for a year! And that’s not even accounting for gas or maintenance!
Why Getting a Car Loan Is a Bad Idea
FAQ
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