Dangerous Debt & Depreciating Assets

Many folks in the personal finance community consider debt to be a tool of the devil.  They would say it encourages overspending and that if you can’t pay cash for something, you can’t afford it.  That’s an aggressive stance, but it’s not completely off base either.  Few could imagine buying a house without a mortgage, and a mortgage is an accepted source of debt.  So then why are car loans so much different?  Why is credit card debt demonized but a mortgage is healthy?

At the highest level, debt is borrowed money that you’ve promised to pay back over time.  The main variable here is the thing you’re buying with your debt.  If you’re committing to making a monthly payment over several years, your side of the deal can quickly sour if the thing you bought no longer brings you value.

Maybe you bought a new car with an 84 month loan, but you decided to trade it in after only 71 months (the average length of time Americans keep new cars according to AutoTrader.com).  What about those 13 monthly payments you still owe?  No problem, you will be able to roll those 13 payments into your new loan.

Problem solved, right?

Not exactly.  Now your brand new car you just bought and financed for $25,000 actually has $30,000 worth of debt attached to it, because you rolled your remaining payments on your old car into the new one.  Let’s assume you rolled it into a new 84 month loan.

Why does that matter? I can still afford the monthly payment, so who cares?

Playing devil’s advocate, let’s say you spend exactly one year driving your new car.  The car has all the latest electronics, it runs perfectly, and it looks great.  Last night there was a big storm that rolled through town which knocked down a huge oak tree, and it landed square on your new car.


Obviously I have car insurance which covers this, I still don’t see the problem here.

Fortunately no one was injured, but your car was totaled.  That means your insurance company will pay you whatever the market value of your car was immediately before the storm.  According to CarFax.com, a new car depreciates more than 20% in its first year.  You receive a check for $20,000.  You look back at last month’s car note and you realize you still owe $26,000.

Wait a minute…

All of a sudden you’re in the hole $6,000, and that’s before you replace the car that was just destroyed.  Now you’re in a tough spot.  You’ve been financing a depreciating asset, and a combination of bad choices and bad luck has caught up to you.

What is a depreciating asset?

A depreciating asset is something that naturally loses value over time.  Except in very rare cases, all consumer goods are depreciating assets.  Your TV, computer, clothes, car, and furniture all decline in value over time.  And it makes sense; would you pay full price or above full price for used furniture?  Of course not, you would just buy brand new at that point.

Conversely, an appreciating asset is something that naturally increases in value over time.  These include real estate, financial assets like stocks and bonds, precious metals including gold and silver, and other rare and collectible property such as artwork, antiques, or classic cars.

What difference does it make?  Don’t houses decrease in value?

For the majority of American history, homes have been a safe investment which increase in value over time.  That increasing value is derived from the the land itself as opposed to the house.  Houses don’t last forever but land typically does.  While there are many exceptions, the rule applies that real estate generally increases in value whereas cars and other consumer goods almost always decrease in value.  So when it comes time to sell the house, you will be able to sell it for more than you paid.  This means you’ll be able to cover the entire remainder of the loan with the sale proceeds and you might even receive profit on top of that!

For that reason, a mortgage is an acceptable form of debt whereas other consumer debt like credit cards and car loans are risky.  If you had to sell the asset today, a house could normally cover the value of the mortgage.  On the other hand, a car, clothes, electronics, or furniture sold today would almost never cover the value of the loan and instead would leave you with a remaining debt to pay out of pocket.

People often fall into consumer debt by trying to keep up with the Joneses.  The Joneses Are a Bad Influence!  While it is better to avoid consumer debt in the first place, you can insure yourself from the risks of a car loan or consumer debt with a proper emergency fund.

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