As college students, we’re comfortable with debt. We have no problem taking out loans for our education or swiping our credit cards when we don’t have the money to buy the things we need. And, because debt isn’t something that’s possible to tangibly see, we’re often ready to keep piling it on without a second thought.
The same mentality often goes into buying a car. We want something cool now, and we assume that we’ll have to pay for it later. Most people assume that there’s no way to get a car without an auto loan. They’re wrong. Today, we’re going to look at why and also why taking out a loan, if you can help it, is a poor choice financially when it comes to purchasing your next car.
Let’s start by discussing why it’s almost always unnecessary to buy a brand new car:
They’re a Bad Investment
Buying something brand new can often be a great investment. When it comes to purchasing a car, nothing could be farther from the truth. Cars don’t hold value like most assets. In fact, a car starts to lose its value as soon as you purchase it. Buying a used car that’s around 5 years old lets someone else take the brunt of that depreciation, passing substantial savings on to you.
Buying Used Cars
It’s obviously much cheaper to buy a used car. But, as we’ve already established, used cars that are 5 or 6 years old can still cost you more than $10,000. Not every college student necessarily has that kind of money lying around!
So what do you do? Your first thought might be to do what most people do: borrow it. That’s an option. And since you’re purchasing a used car instead of a new one so we won’t be borrowing as much. That’s something right?
Let’s look at why auto loans really aren’t actually the best option.
Debt can quickly get ugly. You likely already know that if you take out an auto loan and aren’t able to make your monthly payments, you’ll quickly destroy your credit score.
Even if you make your payments on time, however, you might get stuck with what’s known as an underwater loan. In the case of an auto loan, “underwater” means that you owe more money on your car than it’s actually worth. For example, let’s say that you owe $17,000 on a $30,000 car. However, because you’ve had the car for a few years, it’s now worth $13,000 (referred to as “book value”). You’d be “underwater” or “upside-down” $4,000 because you still have to pay back the $4,000, even if you get rid of the car.
Auto loans are actually “better” than a lot of other loans because they charge you simple interest instead of compound interest.
Here’s the difference: compound interest accrues on your principal (the amount you originally borrowed) plus the interest that you accumulate over the course of paying off your loan. Simple interest, on the other hand, only accrues on your principle. This saves you a bit of money, though you’re still stuck paying more than the car is actually worth.
As an example, let’s say you take out a loan on your $30,000 car. If you get a $30,000 loan with a 5% annual interest rate and pay it off in 5 years, you’ll have paid an extra $7,500 in interest on top of the $30,000. That’s a pretty decent chunk of money.
The Cost of Car Insurance
When you decide to purchase a car, most states require you to also purchase car insurance. There are basically two types of insurance coverage you can get for your car: liability and full coverage. If you cause an accident, liability insurance only covers the cost of damages to the other person. Full coverage covers both damages to you and to the other person.
liability versus full coverage
Obviously, purchasing full coverage is going to cost you more per month than liability insurance would. Most people who own a used car opt-out of full coverage because, in the long run, it costs them more than the vehicle is worth.
However, if you get an auto loan, you’re required by the lender to purchase full coverage for the vehicle until the car is paid off. This is a safety net for the lender and is totally reasonable. If you just purchased a $30,000 car using an auto loan and total the car while leaving the dealership, it’s highly unlikely that you would want to continue making your monthly payments on a car that you can no longer drive.
Unfortunately for you, having to purchase full coverage costs you big time in the long run. Insurance companies are all different and their rates will vary but typically full coverage will cost you about 3-4x more per month than liability. The rates from my personal insurance company reflect this. Simple liability coverage on my car costs $70 a month while full coverage would cost me a whopping $230.
If I had bought my car with an auto loan, that’s an extra $160 I would pay each month which adds up to an extra $1,920 each year. That means that if you take 5 years paying off your auto loan then you have spent an extra $9,600.00 that you didn’t have to!
If you add the $9,600 you will have to pay for full coverage to the $7,500 worth of interest you’ll pay that’s $17,100. That’s more than enough to buy a second, used car! While interest rates and coverage rates will vary from person to person the concept still remains: By the time you’ve paid off 1 car you could have bought 2.
what should you do?
While not everyone is able or willing to save up for a car and buy it in cash, it’s obviously the better option financially. If you choose to get an auto loan you’ll find yourself in a cycle of having finally paid off a car that will probably need to be replaced within several years, forcing you to take out another auto loan.
If at all possible, start saving up to purchase your next car with cash. Then start putting away some of that money you would have been spending on insurance payments towards saving up for your next car. By the time your current one finally bites the dust, you’ll have enough saved up to purchase your next one. That’s definitely a much better cycle to be in.