Saturday, August 4, 2007

Retirement Planning and Debt: Depreciation

Retirement Planning and Debt: Depreciation

How often have you heard someone say that as soon as you drive a car off the lot, it is no longer worth what you paid? There is a lot of truth to the statement but some of it is exaggerated. Yes, it does lose value but not as dramatically as you might think – at least in those initial moments anyway.

Depreciation happens to things with a fixed life span. We know that cars do not last forever. While they aren’t exactly disposable, many vehicles have a fixed life from an accounting point of view.

While you can have an effect on that life span – unusually hard driving might create more wear and tear on a car than accounting calls “normal”, generally speaking, depreciation allows for a systematic lessening of the value of the property over the course of time. In the case of cars, five years is considered by many to be the best number to use.

Another term you may have heard of – GAAP or Generally Accepted Accounting Principles is the method used to adjust the book value of the asset downward in a systematic way. When you buy an asset such as a car, the price you pay is considered the historic value. The book value is considered a contra asset account, each entry lowering the price of the asset.

Autos use straight-line depreciation. This assumes two things. The first is the historic value; the second is referred to as the salvage value. As a math sentence, it would like this:
Cost of the car ÷the salvage value = the annual straight-line depreciation.

In the book, we look at the difficulties of getting you right side up in an upside down car loan. To be “upside down” suggests a car loan that continues long after the depreciation that as brought the car’s value to zero.

One of the key factors in such a mistake is the attraction of “the right price”. Too often we are drawn by the amount of the monthly payment and not the cost of financing the purchase. Had we calculated the debt service (the amount of interest paid) and the depreciation (how much the car will be worth at a given point in time) against the balance owed, we might have had second thoughts about a loan that lasts longer than five.

For instance, which would you find more alluring: a five year loan on a car worth $30,000 at 6% would cost you $579.98 or a seven year loan – not unheard of these days at the same interest rate and a payment of $438.26? Admit it. The lesser of the two would be the most attractive option.

Key to keeping this happening is buying a car you can afford – not the car you want and use the money saved to finance that under-funded retirement.