Lesson 10: Auto Loan (Liabilities)
Liabilities = Debt. Since your Net Worth = Assets - Liabilities, debt works against your Net Worth. As stated in a previous lesson, the more money you owe to others the less of your money you own. The common liability types/accounts are auto loans, mortgage loans, student loans, and credit cards. I will cover each over the next few lessons, beginning with loans for automobiles.
With the average cost of new cars at about $35,000 and used cars at $20,000, most people need auto loans to purchase vehicles. There are two ways funds are transmitted with auto loans; the lender pays the seller directly then you owe the lender back or the lender gives you cash for you to pay the seller then you owe the lender back. Either way results in you owing a lender back a large amount of money and a hit to your Net Worth. Let's see some examples so you can see the Balance Sheet affects of opening an auto loan and making monthly payments.
Example 10-1: You purchase a new vehicle that costs $35,000 with an Auto Loan from the local credit union. You make a down payment of $5,000 and finance the other $30,000 with the following terms: 5 years, 4% interest. The car currently sells for $30,000 on the resell market.
Part 1 - The purchase
Left (Asset) side: The $5,000 down payment decreases your Checking Account. By owning the vehicle, you now own the associated asset value. Since the car can immediately resell for $30,000, that is the asset value on your Balance Sheet. The $30,000 debit entry and the $5,000 credit entry results in an increase of $25,000 in your total asset value. Before you get too happy, the right side must be factored.
Liabilities: You own the asset value but you also own the debt balance for the auto loan of $30,000. Remember, the debit/credit mechanics for liability accounts are reverse that of asset accounts. Therefore, a credit entry of $30,000 increases the Auto Loan Account and represents the debt you owe over the next 5 years.
Equity: You have added $25,000 worth of assets and $30,000 worth of liabilities, therefore the Balance Sheet needs another entry to actually achieve balance. This missing entry represents your Net Worth change from the vehicle purchase; a $5,000 loss. If you think it through, the decrease in equity makes complete sense. You paid $35,000 for an asset you can only sell for $30,000. This is why the popular saying is "a new car is one of the worst investments you can make." You will see the truth in that common saying by the end of this lesson.
Assets = Liabilities + Equity
($5,000) + $30,000 = $30,000 + ($5,000)
$25,000 = $25,000
Important Note: The "$25,000 =$25,000" portion of this does not mean your Net Worth increased by $25,000. As shown in the Equity section, your Net Worth decreases by $5,000 because of the purchases. The "$25,000 =$25,000" portion simply means the transaction is balanced and in accordance with the rules of the Balance Sheet.
Part 2 - Monthly payments
A month or so has passed and you now have to pay off the auto loan. The closer the debt balance gets to $0, the better for your Net Worth! However, you also owe monthly interest to the credit union (lender) based on your outstanding balance. The interest is a monthly Expense that decreases Net Worth.
As a reminder, here are the terms of the loan:
Principal: $30,000 (Principal = amount you borrow and owe)
Length: 5 years
With these terms, the monthly payment would be $552 over the next 5 years. The kicker is that the entire $552 does not get applied against your debt balance. Most of it does, but not all. The $552 includes the monthly interest you owe. Since the interest rate gets applied against the loan balance on a monthly basis, and you are also decreasing the loan balance on a monthly basis, the amount of monthly interest you pay decreases each month. But the monthly interest is very high at the beginning of ALL loans because the loan balance (amount you owe) is the highest in the beginning and decreases over time. This is a very important concept to understand because it's the hidden equity killer of debt. Unfortunately, almost everybody leans on debt but very few actually understand how it works.
To show you exactly what I mean, I used an online loan scheduler and plugged in the numbers from our example. It produced a complete picture of each monthly payment over the course of the 5 year loan, and breaks down the amount of each payment to be applied against the loan balance (decreasing the liability) vs the amount to be paid in interest (decreasing Net Worth). The figure below shows the first year (12 payments) of the results:
The interest column shows the monthly interest with each payment. The principal column shows the amount that goes directly against the loan with each payment. The balance column shows the running balance of the debt (principal) owed. The balance column does not factor the interest column, because interest payments are expenses and do not decrease the loan balance. In other words, Current Balance = Last month's balance - This month's principal payment.
The most important takeaway from Figure 10B is the principal/interest ratio of each payment as the year progresses. First, take a look at the interest column for the first payment vs payment #12; it decreases. Then take a look at the principal column and you will notice an inverse relationship; it increases. As you pay the debt balance down, the amount of interest you owe decreases which means more of your payments are applied against the loan principal. It is crucial that you understand this concept about debt for the next couple lessons as well.
Figure 10C shows the Balance Sheet affects of the first payment:
*The red squares indicate the entries added for this transaction. The $30,000 credit entry was previously added in part 1.
Left (Asset) side: The payment of $552 decreases (credits) your Checking Account.
Liabilities: Remember, the principal portion is applied against the debt. Therefore, that portion of the payment is applied against the debt account, with a debit entry that lowers the debt balance.
Equity: The interest portion is an expense that increases (debits) the Auto Loan Interest account.
Assets = Liabilities + Equity
($552) = ($452) + ($100)
($552) = ($552)
Figure 10E below shows the final year of the loan. You will see that the amount of monthly interest continues to dwindle down over the course of the loan (down to almost $0) as the monthly principal slowly rises and the balance decreases (down to $0):
The figure below shows the Balance Sheet when you make the final payment and pay off the loan!
Left (Asset) side: The payment of $553 decreases (credits) your Checking Account.
Liabilities: Again, the principal portion is applied against the debt account with a debit entry that lowers the debt balance. The previous balance was $551 (per Figure 10E, November balance) so the final payment of $551 lowers the balance to $0.
Equity: The interest portion is an expense that increases (debits) the Auto Loan Interest account by a minimal amount. But when it is all said and one, you paid a total of $3,150 in interest over the four years.
Assets = Liabilities + Equity
($553) = ($551) + ($2)
($553) = ($553)
As you can see, you incur a significant loss on Net Worth when purchasing the vehicle (part 1) plus additional monthly Interest Expenses for borrowing the money (part 2). Borrowing $30,000 at 4% interest over 5 years ends up costing you $3,150 in Interest. This highlights the importance of understand how finances work. That 4% interest rate means you actually pay 10% over the course of the loan (without even factoring the time value of money). And it gets worse...
Part 3 - Depreciation
As mentioned, a new vehicle is one of the worst investments you can make because it is not really an investment. Investments are assets that increase in value, meaning they appreciate; that is what makes them investments. Vehicles are depreciating assets, meaning their values decrease over time. The monthly interest expenses, just covered in part 2, certainly do not help your Net Worth, but it is the depreciation expense that officially takes vehicles out of the investment category.
Vehicles' average depreciation rate is 15% each year for the first five years (depending on different circumstances). This is a very fast rate of depreciation because the wear and tear on the engine, body and interior + the social psychology behind vehicles. Most people would rather not risk buying somebody else's problem, and the risk of problems increases with age. Therefore, the amount that people are willing to pay for a used car decreases greatly as the car ages, all but wiping out the majority of the value within the first 5 years (again, depending on the circumstances).
A 15% depreciation rate for a vehicle that costs $35,000 comes out to $5,250. We'll just call it $5,000. This means a new vehicle that costs $35,000 will be valued at $30,000 after year 1. This was covered in Part 1 since the Vehicle Asset account was increased by $30,000 (instead of $35,000) and you incurred an expense of $5,000 upon purchasing the vehicle.
In year 2, the value of the vehicle will depreciate again since the public is likely to pay less at that point (if you chose to sell). The figures below show the continued depreciation over the course of the first five years and the result on the asset account/value:
As you see, the yearly depreciation dramatically decreases the asset's value over time. In just five years, the car you paid $35,000 for is now worth $10,000 (this is a hypothetical example, actual depreciation of individual vehicles depends on different variables). What's not shown in the figures is the accompanying debit entries on the equity side that decreases your Net Worth by $20,000 over the same time.
The most confusing part about depreciation on a personal vehicle is that it is an unrealized loss; meaning it is not an expense you "feel" or see in your cash accounts even though it technically lowers your Net Worth. You only "feel" it if you need to sell the vehicle soon after buying it. If you use the vehicle for 15 years then that loss of value is largely irrelevant to you, because you received great value from using the vehicle and are comfortable with the full $35,000 expense.
However, let's say it is year 2 and you experience a life emergency that forces you to sell the vehicle (or if you plain just don't like it anymore). You would have to, hypothetically, sell for $10,000 less than you paid. At that point the loss becomes realized and you feel the pain of the rapid rate of depreciation. However, the loss to Net Worth occurs whether you sell the vehicle or not. Asset values are always based on the market value at that point in time, whether you want to sell them or not. If your asset loses value, then your Net Worth simultaneously decreases whether you know it or not (and whether or not you care).
Auto Loan Example in Summary:
Part 1 The Purchase
Assets: Checking Account decreases by down payment amount + Vehicle Account increases by market value
Liabilities: Auto Loan Account increases by the amount needed for financing (the amount not covered by down payment)
Equity: Your Net Worth decreases. The Expense: Vehicle Purchase account is increased by the difference in purchase price and current market value, representing your loss upon purchase.
Part 2 The Loan
You make a monthly payment to ultimately pay back the money you owe. This payment decreases your Asset: Checking Account on the left side of the Balance Sheet, but it is split across the loan account and interest account on the right side.
A portion of each monthly payment is applied to the principal you owe. This portion does not change your Net Worth since the liability decreases, which is good. Even better, it helps your Net Worth because you will own more of your future income. The principal portion of each payment increases as you pay off the loan and owe less interest. Speaking of...
The other portion of the payment is the interest portion, which is an expense that decreases your Net Worth. The interest portion of each monthly payment decreases as you pay off the loan.
Part 3 Depreciation
Vehicles lose value over time, at a rapid rate. The unrealized loss on value is recorded as a depreciation expense on your Balance Sheet, which reduces your Net Worth and the book value of the asset. The loss becomes realized once you sell the vehicle or after several years of owning.
This example (and the mechanics of an auto loan) is not a way to say "auto loans are bad and people that finance purchases with them are irresponsible." Not at all; debt is necessary in a lot of cases. Plus you are not buying the vehicle as an investment, you are buying it to drive to and from important places. However, it is irresponsible to take out a five digit loan for a depreciating asset without understanding the way debt works.
As you can see from this detailed example, there is a lot going on behind the scenes when you use a loan to purchase a vehicle. It may be tough to grasp some of the concepts here but if you can truly understand them, you will be better equipped in the wild world of finances. The next lesson shows you the favorable side of debt using examples of a mortgage loan to help explain. Click here to see exactly how home ownership helps build wealth and maximize your Net Worth!