Upside-down auto loans

Borrowing money to purchase a depreciating asset, like a car, is usually ill-advised for two reasons.

First, if the consumer could not meet the monthly debt service of a loan, ideally, he might be able to sell the asset collateralizing the debt and pay off the loan. If an asset depreciated too quickly, however, or if the term of the loan is too long (it is not uncommon to see auto lenders making seven-year loans in an attempt to create lower and more manageable monthly payments), the asset may depreciate to a value below the loan payoff.

This is referred to as being “upside-down” on a loan. The problem is that if the car had to be sold to eliminate the monthly payment in an attempt to make ends meet, and the value of the car is less than the amount of the loan payoff, the consumer would have to come up with additional (and perhaps substantial) money just to sell the car.

Chances are that if the owner is selling the car because they are financially strapped, they do not have the extra money needed to pay off the loan. This is obviously trouble, and the scenario unfolds surprisingly frequently: 40 percent of new car buyers owe more on their trade-in than the trade-in is worth (source: bankrate.com)

The second and most important reason that auto debt is not ideal is that it tends to siphon too much money away from an individual’s long-term savings plan. Let’s look at an example

Suppose Mike, age 35, drives a five-year-old used car, namely a fully-paid-for 2003 vehicle. The car is worth about $13,000 and has 60,000 miles on it. Suppose Mike trades in his 2003 for a new 2008 car for $30,000. He finances $17,000 ($30,000 for the new car minus $13,000 for the value of his trade-in) for five years at 6 percent. His monthly payment is about $325. So far, so good.

Mike is driving a beautiful new car with that wonderful new car smell. At the end of the five-year period, Mike once again owns the car free and clear. Once again, however, he is now the owner of a five-year-old car worth perhaps $15,000.

Now, let’s suppose that Mike did not buy the new 2008 car and instead decided to drive his 2003 car for five more years. And, rather than plunking down the $325 a month toward his would-be car payment, he instead invested the $325 a month into his Roth IRA for the five-year period. If Mike never added to the Roth IRA again, and the five years of would-be car payments were to compound at 9 percent, what would the value of his Roth IRA be at age 65? … $211,265.

All of the sudden that car is looking a little more expensive! Conversely, what would the value of Mike’s 2008 car be in 2038, when Mike turns 65? Probably nothing (keep in mind this is a hypothetical illustration and is not intended to reflect actual performance of any particular security).

Maybe that new car is costing Mike more than he realizes, and this is exactly why consumers must be careful when financing a depreciating asset. Not only are they making payments toward an asset that is losing its value, they are not making a payment to an asset that is appreciating. The verdict on auto debt… sometimes necessary, but definitely not ideal.

Submitted article by Jeff Reish, a financial advisor with Raymond James Financial Services, Inc., member FINRA/SIPC, located at 618 Macon Ave. in Cañon City.