Societal norms. Misleading advertising. Little or no understanding about the true costs of cars. The reasons vary, but the truth is firmly established: cars are bad debt.

Because most people need cars to get around, they view them as an expense rather than a debt. But in reality, vehicles are depreciating assets with significant ongoing expenses.

Even so, you don't have to avoid buying a vehicle—as long as you understand the financial implications discussed in this post.

What is bad debt?

A simple rule about debt is that if it increases your net worth or has future value, it’s good debt. If it doesn’t do that and you don’t have cash to pay for it, it’s bad debt.

What separates good from bad debt is often how it is managed. For example, obtaining a business loan can increase your wealth as long as you pay it promptly. For that reason, it’s considered a positive form of debt.

Examples of good debt include mortgages, student loans, small business loans, and sometimes credit cards and personal loans. These loans can be used to build equity or increase your earnings if used wisely.

Take your credit card, for example. Overspending with nothing to show for it is bad debt. But buying a new laptop on credit may boost your business's profits and can improve your credit score and net worth.

Why are cars considered bad debt?

By that same logic, you could argue that a car allows you to get to work, which grows your wealth. If that’s the case, why is buying a car considered bad debt?

Unless you're buying a rare collector's item, the value of your car will decrease over time. After one year, it will be worth 20% less than what you bought it for assuming you bought it brand new.

After five years, it will depreciate by 15-25% every year until it hits the five-year mark, which means it will not be worth nearly as much as the amount you paid.

Add repairs, maintenance costs, and required insurance and it becomes increasingly difficult to recoup the initial cost through resale, especially because most are paying high interest on their car loans.

To profit, lenders charge higher interest rates to compensate for the decreasing value of a car. Average interest rates currently range from 5.07% to 14.8% for new cars and 7.09% to 21.38% for used cars.

The financially smart way to buy a car

Having some knowledge and the ability to resist pushy sales tactics makes purchasing a car more affordable and less stressful.

1. Know what you can afford

As a rule of thumb, you shouldn’t spend more than 10% of your gross income (total before tax) on a car payment + insurance.

A larger down payment (at least 20%) lowers your monthly payments and reduces interest, so it's worth saving up beforehand if you don’t already have cash set aside.

2. Buy second hand

In the second quarter of 2023, the typical monthly installment for a pre-owned car was $528, compared to $729 for those financing a new vehicle, as reported by Experian.

Opting for a used car instead of a new one could save you over $200 each month, ultimately leading to significant long-term savings reaching thousands of dollars.

3. Avoid long loan terms

Car loans can last up to 96 months. While reduced monthly payments sound like a good idea, the interest you’ll pay will be far higher over the long term.

Paying off a car in three years will save you substantial money and improve your credit score. Furthermore, you’ll avoid being upside down on your loan.

This is when the amount you owe on your car is higher than its current value. Because negative equity is common with all car loans, it is essential to pay them off as soon as possible.

5. Don’t fall for expensive add-ons

Dealerships may try to upsell you on extended warranties and sports packages for an extra cost. However, in the case of warranties, these additions don’t provide sufficient value to justify the higher price.

Don’t fall for their sales tactics, especially if you can’t afford the car upfront. Otherwise, you may have a significantly more expensive vehicle without any real benefit.

6. Compare Insurance Rates

It's also common for car dealers to offer a referral to a specific insurance provider, but it's important to do research and not just take their word for it.

Contact multiple reputable companies to find the best deal. You can ask providers if they’re willing to match your lowest quote and negotiate for better coverage at a lower price.

What about leasing a car?

With rising interest rates, leasing a car seems like an attractive option. In fact, the average monthly car lease cost is $487 compared to a new car payment of $548.

If you lease, however, you’ll never have equity in the vehicle. This means you can’t sell it for cash; any money spent on it will only benefit the lender. So, it’s not the best option if you want to own a vehicle long-term.

Opt for less debt and more freedom

For many people, buying a car is an unavoidable “bad” debt because more affordable modes of transportation may not be feasible or convenient. But with careful budgeting and financial planning, you can minimize the burden.

Remember to pay your auto loan off as soon as you can. The less money you shell out for a car, the more you can put toward other financial goals, and that’s a great step toward building wealth.