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Tuesday, November 7, 2017

Cars are a long-term payment scheme

“The bottom line is that most people do not buy a home but rather commit to a long-term payment scheme.”

Izabella Kaminska, FTAlphaville, November 7, 2017

And the good phrasing doesn't stop there: her line refers to a Convexity Maven (Harley Bassman) note "House of Cards."

The above lede on the Financial Time's Alphaville blog caught my eye. It applies equally to the auto industry. Over 70% of new car purchasers use some sort of finance, and trade those wheels in before the loan matures for another financed "ride". At a 7.6% interest rate (the base rate from a major OEM's web site), and with a 7-year loan, a "purchaser" will still owe half the face value of the loan at the 4 year point. With 17% depreciation per year, their trade-in will just equal their loan value in the 52nd month.

Even I took out a loan – a 0.9% financing deal was too good to refuse. However, I didn't do a long loan, only 4 years, and I put 50% down so that I'd never be upside down. As it turns out, though, interest rates have stayed really low, and my short-term savings hasn't been earning at best 0.1%. So I might just as well have dipped into savings and paid cash for the whole thing. In any case, the four year consolation prize of being free of car payments will soon be here.

The point at which someone trapped in a long-term car payment scheme breaks even will vary with the depreciation rate, interest rate and length of the loan. Here are sample calculations. Note that a shorter-maturity loan pays down much more principle in the first year, and so purchasers aren't underwater for long. The cost, of course, is a higher monthly payment. Here I assume (unrealistically) that the loan is for 100% of the car value as reflected in the resale market – no extended service plan rolled in, no downpayment. The number of permutations with the latter is unwieldy. So if the car is valued at $60,000, then with a $10,000 downpayment (or tradein plus incentives), an 84-month, 7.6% loan remains rightside-up throughout but provides $5000 equity only in the first year, before that $60K has depreciated much, and then again from the 55th month.

Car payment calculations, $50,000 loan
Upside down