Don't chase equity with a pricey automobile

I get so frustrated when I hear people try to justify buying an expensive car they can't really afford by saying, "Well, it'll hold its value."

The truth is no vehicle holds its value unless it's a classic or rare car.

That Mercedes-Benz E-Class you desire may depreciate at a slower annual rate than a Mercury Monterey, but both cars will lose significant value the second they leave the dealership.

"Depreciation often is the greatest expense incurred by drivers during the first five years of vehicle ownership," says Robyn Eckard, a spokeswoman for Kelley Blue Book, a leading provider of new- and used-vehicle information.

The average vehicle retains only about 35 percent of its original value after a five-year ownership period, meaning that a car bought new today for $20,000 will be worth $7,000 after five years. By the way, a Mercedes E350 retains only 36 percent of its value after five years, according to Eckard. The Mercury Monterey fares worse, retaining only 21 percent.

Car valuations matter because an increasing number of consumers are upside down on their auto loans, meaning they owe more than the car is worth. In the first quarter of this year, 29 percent of consumers were upside down on their vehicles, Kelley Blue Book reports. Additionally, on average, people traded in cars on which they still owed more than $3,600. And what do these buyers do with that loan balance when they want another car? They roll that negative equity -- the $3,600 and often much more -- into yet another vehicle loan.

"It is a pandemic," says Jack Nerad, executive market analyst for Kelley Blue Book. It is also financial lunacy. And making matters worse are risky lending practices similar to what we've been seeing in the mortgage industry.

Increased pressure on automakers and dealerships to sell vehicles over the past few years has led to more car loans being made to riskier borrowers. Auto dealerships originated $50 billion in new-vehicle loans to subprime borrowers last year, according to retail data from the Power Information Network , a division of J.D. Power and Associates, a marketing research firm.

To make the loans work for many of these subprime borrowers, who typically have shaky credit, the lenders are offering car loans with longer payment periods. New car loans lasting more than five years in 2006 accounted for nearly 55 percent of loan originations, according to the Consumer Bankers Association.

Subprime vehicle buyers, those with credit scores below 650, have loans that last an average of 61 months, compared with 56 months for more creditworthy consumers, the Power Information Network found. Higher-risk buyers also tend to make lower down payments as a percentage of the purchase price, paying about 11.6 percent compared with 17.4 percent for other buyers.

The same factors that are pushing subprime homeowners into foreclosure -- rising interest rates on credit cards and home loans -- could cause subprime car owners to default on their vehicle loans, said David McKay, senior director of auto finance and insurance at J.D. Power and Associates.

To stop this madness and avoid being upside down on your vehicle or rolling debt into another loan, there are at least two things you should do.

First, use a 48-month car loan as a benchmark for affordability. If you can't handle the monthly payments with a four-year loan, you probably can't afford the vehicle you'd like to buy.

Next, you should research the resale value of the car you're interested in purchasing. This will help you see that getting a long loan on a particular model could be trouble, especially if you tend to trade in and out of cars. Kelley Blue Book now provides a depreciation chart on its website, kbb.com, that shows projected resale values for all new vehicles.

But even if the car you select has a good resale rating, it's still a depreciating asset. What I'm asking is that you change your thinking about what a car is worth. And I'm not quibbling over semantics. There is a substantial difference between assets that have the potential to appreciate or that truly hold their value vs. those that depreciate year after year. Your goal should be to put more of your money in appreciating assets.

Michelle Singletary is a columnist for The Washington Post. She can be reached at singletarym@washpost.com.