Like any other valuable asset that can become worn down through normal use, a car loses some of its value each year through general aging and every day wear and tear. This loss in value is known as car depreciation. Depreciation is primarily an accounting tool, rather than an accurate representation of the wear and tear a car receives on a yearly basis.
The rate of car depreciation varies depending on the year, make and model of the car. The first year always sees the greatest depreciation hit against the car's market value, with most cars losing about 20 percent or more of their original value. The loss continues onward from there, with cars shedding about 60 percent of their original purchase price within the first five years on average. When the time comes to sell your car, you may find that depreciation has greatly reduced the expected trade-in value for what could still be a well-functioning, nearly-new automobile.
A car's trade-in value is the amount of money an auto dealer is willing to take off the purchase price of a new or used car in trade for your existing car. The trade-in amount is based on a number of factors, including the make and model of the car, its age, and its condition at the time of trade. Because of depreciation, the older your car is at the time of trade-in, the less credit toward a new purchase you're likely to receive. Holding onto your car for longer than average can be a benefit at trade-in time if the vehicle is in good condition, because the rate of depreciation tends to slow after the 100,000-mile point. There are a few exceptions, of course, with very popular car models receiving higher trade-in deals.
Depreciation continues to affect a car each year until its value on paper is zero. For accounting purposes, the car at this point no longer counts as an asset, regardless of its actual condition. If your zero-value vehicle were to be totaled in an accident, you would be unlikely to collect enough from an insurance company to purchase a replacement -- or to pay off any remaining financing you received towards the car purchase.
Smart buyers looking for a good deal can make car depreciation work in their favor. Used cars are much lower in price than new cars because depreciation affects a car regardless of its condition. You can purchase a 1-year-old car that's nearly as good as when it was new, but you'll pay only 80 percent or so of the original price. Similar savings can be had by taking out a car lease.
Depreciation works well as an accounting method to show the effects of normal use on the value of a car over time. Even though it's not precisely accurate, car depreciation will still provide a car owner with a rough estimate of a car's market value. This estimate is considered good enough when listing the car's value as an asset for business or tax matters.