A family member recently came to me with a problem. This person had been given (in my opinion) very bad advice, and bought a car. Recently, this car was in an accident, and the insurance was sending a check. The choices were:
- Spend the money on its intended purpose and repairing the vehicle back to the way it was
- Spend some of the money and bank the rest
- Spend some of the money on the car, trade it in and use the rest as a down payment for another car
- Save all the money.
This person was convinced that the right answer was to trade in her car for a newer one that would have less miles and less problems. Hopefully, I convinced her otherwise.
What she wanted to do is pretty common for young people. She is making payments on a car, and she figured that it made sense to roll that loan into a loan on a newer car, and extend the term.
Her car was worth about $2700, and she owes about 3,000. This gets into the concept of NEGATIVE EQUITY
Many many, many, MANY young people feel that the vehicle they are in now sucks so bad that it will be worth paying a little extra just to get into something better. The problem is, young people can’t usually afford something much better than what they are driving. This puts them in another sucky car, and another one (all with balances from previous cars being tacked on), until they are paying premium car prices for economy cars.
My advice to my family member: Fix what needs to be fixed so it is functional. Put the remainder down on the principal of the loan. If you have any wiggle room in your budget at all, put some extra each month to the principal as well. Once your car is paid off, decrease your insurance coverage to be more in line with the risk, but keep making the same car payment — to a savings account. Drive your car until it gives up completely, and use the savings you’ve built as a down payment towards a new(er) vehicle. The payments you have been making to savings can now be your monthly payment. You know you can afford it, and it won’t break you.
“But all the other PF people say it’s dumb to finance a vehicle. Wil, how could you suggest something like that?” Look, I still believe young people shouldn’t buy more than they can pay in cash, but I know that people like driving something nicer. And don’t give any crap about paying depreciation. I know it’s not a financially smart move, but, again, it’s only really an issue if you keep trading it in. My point is, IF you feel that you NEED to get a newer car, there are ways to do it, and ways to NOT do it. Negative equity is the way NOT to do it.