Why Making Payments on a Car Is a Poor Financial Decision

Making payments on a car, a common practice involving financing a vehicle purchase through a loan, often leads to significant financial disadvantages. This approach ties up personal capital in an asset that rapidly loses value, incurs substantial financing costs, and diverts funds from potentially lucrative investments. Understanding the underlying financial principles illustrates why this prevalent habit can result in poor financial outcomes for individuals. This article explores these fundamental reasons to highlight the economic realities of car financing.

Rapid Asset Depreciation

Automobiles experience a swift and substantial loss of value from the moment they are acquired. A new car can lose an average of 10% to 20% of its value within the first month or year of ownership, often immediately upon driving it off the dealership lot. This initial decline is the most significant, with the depreciation rate slowing somewhat in subsequent years. By the end of five years, many new vehicles retain less than half of their original purchase price, with some models, such as luxury cars and electric vehicles, depreciating even faster.

This rapid decline means the asset is continuously worth less than the outstanding loan balance. A borrower makes payments on a diminishing asset, creating a growing gap between the amount owed and the vehicle’s market value. This makes it challenging to recoup the initial investment, as the car’s resale value quickly falls below the purchase price. The financial commitment to a depreciating asset represents a constant drain on wealth.

The True Cost of Financing

Financing a car involves more than simply repaying the borrowed principal; it includes a range of additional costs that significantly increase the total expenditure. Interest payments form a substantial portion of these costs, with rates varying based on creditworthiness and whether the vehicle is new or used. For instance, average new car loan interest rates were around 6.73% in the first quarter of 2025, while used car rates averaged 11.87%, with rates for those with lower credit scores potentially exceeding 20%. These interest charges accrue over the loan term, which commonly ranges from 36 to 84 months, with 72 months being a frequent choice.

Longer loan terms, while offering lower monthly payments, result in a much higher total interest paid. For example, extending a loan from 60 to 84 months can add thousands of dollars in interest. Most car loans use simple interest, where interest is calculated on the remaining principal balance, with early payments largely allocated to interest.

Beyond interest, borrowers encounter additional fees. These include origination fees, documentation fees for processing paperwork, and late payment penalties if payments are missed. These various charges significantly increase the overall cost of financing a vehicle.

Lost Investment Opportunities

The funds committed to car payments, encompassing both the principal and interest, represent capital that could otherwise be allocated to appreciating assets. This concept is known as opportunity cost, where choosing one financial path means foregoing the potential benefits of another. Instead of being directed towards a depreciating vehicle, these funds could be invested in various avenues that offer wealth accumulation. For example, consistent contributions to retirement accounts, stock market investments, or even high-yield savings accounts could generate significant returns over time.

Historically, the S&P 500 index has delivered an average annual return of over 10%. By diverting money to car payments, individuals forgo the power of compounding returns, where earnings from investments generate further earnings. The cumulative effect of these missed investment opportunities can amount to a substantial sum over several years. Choosing to finance a car therefore means sacrificing potential long-term financial growth and delaying the achievement of other financial objectives.

The Negative Equity Trap

A significant financial disadvantage of car financing is the risk of falling into the “negative equity” trap, also known as being “upside down” on a loan. This occurs when the outstanding balance on a car loan exceeds the vehicle’s current market value. The combination of rapid depreciation, particularly in the initial years of ownership, and the front-loaded nature of interest payments on simple interest loans often creates this situation. Because less principal is paid down early in the loan term, the car’s value can drop faster than the loan balance decreases, especially with long loan terms or minimal down payments.

Being in negative equity has several adverse financial implications. It makes selling or trading in the vehicle challenging, as the amount received for the car will not cover the remaining loan balance, requiring the owner to pay the difference out of pocket. If the vehicle is totaled or stolen, insurance payouts are typically based on the car’s market value, which may be less than the loan amount, leaving the borrower responsible for the shortfall. Furthermore, negative equity often perpetuates a cycle of debt; borrowers may roll the outstanding balance into a new car loan, increasing the new loan’s principal, monthly payments, and total interest, thereby deepening their financial burden.