Car Loan Trap

I don’t like car loans. The reason for this is you are making payments on a depreciating asset with interest. People often also end up buying a car that is far too expensive for their budget when using loans. The dealer just focuses on the monthly payments not the price of the car. Don’t fall for this trick. Look at the actual price of the car. If it is say $40K you are going to have to pay off that amount plus interest. It takes a LONG TIME to pay off $40k. Too often I see people with limited incomes driving $50K pickups and families with a brand new top of the line SUV costing $60K. I now see car loans with terms of eight years! You don’t want to be paying for repairs and making payments at the same time.

How can you avoid this trap?

  • After you buy a car drive it for ten years to get full value out of it. Most of the depreciation is paid in years 1-3.
  • Buy used! There are lots of two year old cars off lease that are in great shape that are affordable. Used rental cars also fall into this bucket. The kicker is these cars may cost 40% less than new be the same model and still come with the factory warranty. Hertz Car Sales for example sells their used cars off. My wife got a nearly new Camry for $15K instead of $25K.
  • As a general rule of thumb consider car payments of 36 and 48 months max duration. If longer than that you can’t afford it. Go look at a cheaper new or used vehicle.
  • Try to put down as much cash as you can. 20% to 50% down would be nice. Paid in cash is ideal if you can afford it or the car is cheap.
  • Get a low interest rate like 1.9% or 0.9%.
  • Do you research online via sites like True Car to see what people really paid for the car
  • Consider using pre-negotiated prices like Costco auto plan if you are a member
  • Consider selling your car or getting offers on your car instead of just trading it in
  • If you are in the city ask if you need a car at all. Can you take public transit? You can save on payments, maintenance, insurance, parking and gas.

Trap Example #1: Freddy Fool

Freddy Fool is looking for a new car. He likes the new model sporty SUV he saw on TV. Freddy goes to the dealer to look and salesman shows him a model that is just what he likes. The price is $45K. The dealer assures Freddy not to worry as he can make the payments work for even Freddy’s budget.

The dealer quotes Freddy $657/ month over 7 years at 6% interest. He convinces Freddy to buy after some pressure with the sales manager.

Did Freddy get a good deal? No! Here is why.

  • The vehicle costs $45K but by the time Freddy has paid it off he will have paid $53.9K meaning interest charges of $8900.
  • He also paid close to sticker as he didn’t negotiate hard and just focused on the size of the payment as the dealer intended (bamboozled!)
  • His insurance went up as he bought such an expensive vehicle.
  • The vehicle also is depreciating quickly so if Freddy sells it he will take a loss. He is stuck.
  • To make matters worse the recession hits in year five of his payment stream. Freddy loses his job and can’t make the payments. The dealer repossesses his car and he ends up taking the bus until he finds a job. His credit is ruined and he can no longer qualify for new cars. Instead he now drives a used old car with a high interest rate as he is seen as a risky borrower.

Trap Example #2: Sally Smart

Sally is also in the market for a new SUV as she is afraid of the snow in winter and the hills in Stumptown. However unlike Freddy Sally is no sucker.

  • Sally does her research via Consumer Reports checking out reliability records and resale values. She decides to get a Honda small SUV. Sally shops several dealers online and in person. She also checks car buying sites like True Car to see what actual buyers paid for such a vehicle.
  • Sally goes to the dealer armed with the research she has done gets the price down to $25K from $28K using Costco Auto Plan and her data. She also finances the car but over four years instead of seven.
  • She gets $541 per month over four years and 1.9 percent interest. She pays a total of $26K for the car. She pays total interest of $981 and is done in four years. Given the car has great resale value she won’t lose as much down the line, however she plans to drive the car for the next ten years.
  • When the same recession hits in year five Sally also loses her job but has paid off her car so is not worried. She uses the car to find a new job in a nearby city and is back on her feet in no time.

Did Sally get a good deal? Likely yes.

BTW these financial time value of money calculations are not hard. I will teach you how to do those later in this blog. Then you will be able to calculate your own payments including down payments.

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