New Vehicle Woes...

There are few decisions in life that have the potential to cause more grief and woe, more wailing and gnashing of teeth, than the decision to buy a new car or pickup truck. Why is this? There are several reasons:

(1) We buy more car or truck than we need... or we buy one that has too many expensive options that we don't need or won't use; or, worst of all, we buy one that doesn't fit our needs at all.

(2) The monthly payment is more than our budget can handle because we did not have a large enough down payment (or our trade-in was not worth much), or our credit rating was so low that the interest rate on the auto loan was too high;

(3) We do not keep the vehicle long enough to fully amortize the loan, and so we end up rolling the remaining loan balance into the loan on the next vehicle we buy.

Even in the simplest of cases, in which we don't have a trade-in, and we're paying 10% down, we could still end up underwater... owing more on the auto loan than the vehicle is worth. As an example, let's imagine we're buying a new economy vehicle for $24,000. The vehicle is expected to depreciate steadily over the next ten years and be worth $6,000 at the end of ten years. We have a 10% down payment ($2,400), so we'll be financing $21,600 for 84 months (7 years) at 8% annual percentage rate (0.67% per month on the remaining loan balance). Our monthly loan payment will be $337.09. You can confirm this for yourself by entering the following values into this FINANCIAL CALCULATOR:

Present Value: -$21,600 (NOTE: money paid out is NEGATIVE)
Future Value: $0.00
Number of Payments: 84
Interest Rate per period, %: 0.67
Payment At: [End]

Click [PMT] to compute the monthly payment amount of $337.09.

The following graph shows what this transaction looks like. The RED LINE is the value of the vehicle. Notice how it steadily depreciates from $24,000 when new, to $6,000 when it is ten years old. The GREEN LINE is the remaining loan balance. Notice how it starts at $21,600 at year zero, when the vehicle is new, and declines to zero at the end of seven years.



The important thing to notice is that at the one-year point the car value and the loan balance are the same, $19,200. However, for the next three years, the car depreciates faster than the loan balance declines, so you are underwater on the loan. Sometime in year five, the loan balance has declined enough that the car is worth more than the loan balance, and you are no longer underwater.

The problem is that we frequently sell or trade-in our vehicle during this underwater period, rather than keeping it until the loan is paid off, at the end of year seven, or at least until the car is worth more than the loan balance.