Being upside down on a car loan means that you can’t even get a profit from selling it! So what should you do when you find yourself stuck in such a bad car loan? This post will tell you everything you need to know.
When shopping for a car loan, all you think about is whether you can manage the monthly payments. So imagine your surprise when you try to sell the car halfway through the loan and realize that you owe more on the loan than what it costs! This is commonly called being “upside-down” or “underwater” on your car loan.
While it’s not necessarily a bad thing to be upside down on your car loan, it might complicate things in certain situations. This explainer post will break it all down for you!
What is an upside-down car loan?
Simply put, being upside down on your car loan means that you owe more than the car is worth. This is also called having negative equity in your vehicle. Even if you sell off the car to repay the loan, you will not be able to cover the entire remaining loan balance. For example, if you have a loan balance of $20,000 but the current value of your vehicle is $15,000 – you’re “upside-down” on the car loan.
Why does this happen, you ask?
Cars (and all automobiles) are depreciating assets – most financial experts agree that a car loses at least 20% of its value the moment you drive it off the dealership. So that spanking new vehicle you just bought for $25,000 could cost $5000 less by the time you reach your garage! If you haven’t made a large enough downpayment or have a very long loan term, you could end up paying more than the vehicle’s worth in the long run.
What’s wrong with being upside-down on a car loan?
Having an upside-down car loan can negatively impact your chances of selling the vehicle, trading it in for a cheaper one, or claiming damages if it is totaled. However, if you intend to go through with the loan payments and own the car in the end, then being upside down on the loan won’t really affect you negatively.
Being upside-down on a loan can affect you negatively if:
- You want to sell the car and buy a new one: Downsizing to a cheaper model with lower monthly payments will be difficult if you have negative equity.
- When your car is totaled: If your car is completely totaled in an accident, the insurance company will pay you the current estimated value of your car. Ideally, you can use this money to pay off any remaining loan balance. However, if you’re upside down on the loan, the insurer’s amount won’t cover the whole balance, and you may have to pay out of pocket.
- Trading in your car will be hard because you will have to pay the buyer an amount equivalent to the negative equity in the vehicle to get it off your hands.
How do you end up with an upside-down loan?
The anticipation of sitting behind a new car can cloud your judgment – and this lapse could prove costly for you in the long run! Here are some common reasons buyers end up with an upside-down loan:
- Not making a down payment: If you don’t make a large initial payment that covers a part of the principal and interest due, you could end up upside down on your loan very fast – in as little as a year.
- Taking a long loan term: While the average car loan term is around 60 months, you may be tempted to go for a longer term (72 or 84 months) to get lower monthly payments. While this may seem like a good deal in the short run, over the long run, you could pay higher interest charges which may not make up for the depreciation.
- Not researching vehicle prices: Buying an overpriced car could lead to faster depreciation, especially since similar models cost much lesser at the start.
- Rolling over old loans into a new one: If you want to buy a new car while still owing money on your old one, lenders could convince you to roll over the remaining amount into the new loan. However, this means you will effectively be paying two loans at the same time and will go upside-down faster than usual.
- Taking on a high-interest loan: If you’re taking on a high-interest loan, ensure you choose shorter terms. Longer loan terms will lead to more interest charges, and you may end up underwater quickly.
- Buying a high-end, expensive car with many add-ons: Additional expenses on upholstery, vehicle modification, and entertainment systems can inflate the overall cost of the car while adding little value in the long run.
How to find out if your car loan is upside-down: Steps to follow
You can determine whether you have positive or negative equity in your car using the following steps:
- Ask your lender for the 10-day or 14-day payoff amount. It will tell you how much you owe on the vehicle, including interest charges.
- Use a car valuation service like KBB or Edmunds to estimate your car’s current resale value.
- Crunch the numbers by subtracting the loan balance from your car’s resale value. If the number you get is negative, you’re unfortunately upside down on loan.
How much negative equity is too much?
The best way to determine if the negative equity is too much is to calculate the Loan-to-Value ratio (LTV). Ideally, the loan amount should not exceed 125% of the resale value.
Also read: How to pay off your car loan faster and build equity in your vehicle.
How to get out of an upside-down loan
Getting out of an upside-down loan takes time – so ensure you always keep track of the loan status at regular intervals. If you find yourself underwater, choose any of the below options:
- Choose auto loan refinancing for a shorter term: This will allow you to pay off the old loan while getting a new loan with better conditions. Ideally, you should select an offer with a shorter term so that you can pay off the loan at the earliest. While this may result in higher monthly payments, you can start building equity in the car sooner.
- Make extra ‘principal-only’ payments: The faster you pay off your principal, the sooner you can reduce your negative equity. Make sure you mark extra payments as going towards the principal.
- Continue with the loan until you pay off the balance: This is also called “driving through” the loan. You can choose this option if you intend to own the car at the end of the loan term.
- Roll over the negative equity into a lease: Lease payments are lower than car loan monthly payments. By the time you finish paying the lease payments, your negative equity will also disappear.
Tips to avoid going upside-down on a car loan in the future
- Don’t let the lender roll your negative equity into a new one. You will end up paying for two loans and end up upside down faster.
- Get GAP insurance as a safety net in case your car is totaled when you are underwater on the loan.
- Buy used cars instead of new ones. Used cars depreciate much slower and are also not as expensive as new cars.
- If you want to buy a new car, remember the 20/4/10 rule – make at least a 20% down payment, not more than a four-year term, and the total monthly payment should not exceed 10% of your monthly income.
- Always go for shorter loan repayment terms – it will cost you less in interest charges in the long run and prevent you from going underwater.
Also read: What to do if your car is totaled with an upside-down car loan
Frequently Asked Questions (FAQ)
What happens when you go upside down on a car loan?
When you are upside-down on a car loan, you owe more than what the car is currently worth. Being underwater makes it harder to trade in your car, sell it off, or claim damages if it is totaled.
Can I refinance my car loan if I am upside down?
Yes, you can refinance your car even if you are upside-down on the loan. In fact, refinancing the loan with a shorter term can help you pay it off faster and switch to building positive equity in your car.
How do I get out of an upside-down car loan with negative equity?
You can do one of the following to get out of an upside-down loan:
- Refinance for a shorter loan term
- Make extra payments toward the principal
- Continue paying for the remaining loan term
- Roll over the negative equity into a lease
