Is Your Car Loan in the Danger Zone?

It's bad enough to be in a car accident that results in a total loss, but to add insult to injury you find out from your insurance company that your two year old car is worth only 40% of its original value and then to top it off your finance company tells you that after two years of making payments you've barely made a dent in your loan.

The result? You get a $10,800 check from your insurance company to pay off a $22,000 car loan. Welcome to the danger zone for car loans.

And then you ask yourself, "But how can this be?" To help you find out, let's first look at why your car has lost so much of its value so quickly.

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Every mechanical asset, such as autos, boats, and your personal jet, lose value over time; some much more quickly than others.

The loss of value is called depreciation and, in the case of autos, the speed at which a particular model loses its value is determined by consumer sentiment more than any other factor. Among the top 10 fastest depreciating cars for 2008, the three most frequently cited reasons for owner dissatisfaction were poor handling, mechanical defects and lack of comfort.

The solution to this problem is to buy a vehicle with a high residual value. If it's a new car you're looking for, check the Automotive Lease Guide; they're the recognized authority on predicting the residual value of new cars. A residual value of around 50% after 5 years is very good. On the other hand, the fastest depreciating cars have residual values only in the low 20% range after 5 years.

If you're in the market for a used car, avoid the autos that appear on the yearly Top 10 Fastest Depreciating Cars list and consult the Kelley Blue Book for the current price of the car you're considering. Be on the look out for a wide disparity between the Blue Book price of the car and what the dealer or private party is asking.

The object is to keep the distance in dollars between what the car is worth and the loan balance from getting too far away from each other.

The second action you can take to lessen the chances for a potential financial disaster is to keep your loan term as short as possible. Of course if this was as easy as it sounds the financial institutions wouldn't have a market for 5 year car loans. Although a 5 year loan is more accommodating to the budget of many car buyers, you don't start building up a noticeable amount of equity until you're almost two years into the loan.

No matter how good of a deal you get on a new or used car it's still going to depreciate in value while the balance on your loan remains virtually unchanged for at least the first 16 months on a 5 year loan. The difference between the two amounts is what you, personally, would be responsible for if your car is totaled for any reason.

In most cases this would amount to $6,048 based on an average car payment of $378. Now, you can either buy an insurance policy to cover the $6,000 for about the same cost as one car payment, or you can put your faith in your superbly honed driving skills. The problem with the second choice is the guy that hits you doesn't know what a great driver you are.

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