Auto Loan Math: In Praise of Older Vehicles

Richard Barrington
LoanBiz Columnist

Article Rating , 4 out of 5 based on 1 votes

While it is natural to aspire to buying a new car, there is a sound financial argument in favor of getting a used car instead. It isn't simply that used cars are cheaper overall -- though in today's tight economy, that's an important plus. The argument in favor of buying used also includes the fact that a used car loan is less likely to go through a phase known as being "under water." When the remaining principal on an auto loan exceeds the value of the vehicle, the loan is said to be "under water" or "upside down."  This is actually a fairly common phenomenon with new car loans, but it means the owner has to make a lot of car payments before getting ahead. With a used car, the owner has a better shot at avoiding that hole altogether.

The Race between Amortization and Depreciation

Keeping an auto loan from being under water depends on the race between amortization and depreciation. Amortization is the rate at which car payments retire the remaining principal owed on the loan. Depreciation is the rate at which the value of the car declines.

An auto loan can get under water when the rate of depreciation exceeds the rate of amortization -- that is, when a car declines in value more quickly than the loan is being paid off.

New vs. Used

The reason new car auto loans are so likely to get under water is two-fold. First, the interest component of a car payment is largest in the first months of an auto loan, meaning that principal is paid down at a relatively slow rate initially. Second, the most rapid phase of a car's depreciation is in its first year.

A car's depreciation in the first year has been estimated at being between 15% and 20% of the car's value. In fact, a good chunk of this depreciation takes place as soon as a new car is driven off of the lot. So, it is almost inevitable that a new car loan will spend some time under water.

Used Car Loan Terms

An important consideration for used car loans is that the borrower be realistic about the effective remaining life of the car. The idea is to finish making car payments while the vehicle is operational, so shorter-term loans are often preferable for used cars. Shorter-term loans have the added advantage of amortizing more rapidly, and thus are even more likely to stay above water.


About the Author
Richard Barrington is a freelance writer and novelist who previously spent over twenty years as an investment industry executive.

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