Upside-Down Car Loan Explained
Most new car owners find themselves in the unfortunate position of owing more on their loan than their car is currently worth. Negative equity can be difficult to prevent when purchasing a high-priced vehicle with a tiny down payment and a loan term of five years or more.
When a car’s loan balance is more than its resale value, the situation is known by numerous different names in the auto business. Negative equity is the official term, but “upside-down” or “underwater” on your loan are standard colloquial terms as well. If the car has been stolen, deemed a complete loss by the insurance provider, or you just wish to replace it, the fact that you’re underwater usually isn’t a problem.
What Exactly Is an Upside-Down Car Loan?
When you end up owing more on your car loan than your car is worth, your loan is considered upside-down. If your car is worth $12,000 but you owe $15,000 on the loan, you are upside-down. There is a $3,000 deficit in your equity in this case.
A car with a loan-to-value (LTV) ratio above 100% is considered “underwater.” Lenders use the loan-to-value (LTV) ratio as a basis for their interest rates and other loan terms.
Having negative equity on a car loan isn’t necessarily a problem. Your loan can be paid off early if you don’t intend to sell the car before its term is out. Having this information will not affect your relationship with your lender in any way.
However, it may complicate matters in specific instances. You’ll have to clear up that negative equity if you wish to trade in your car. Once your car is destroyed, the same stands true. Further, having a negative equity position can make it more challenging to qualify for a low-interest car loan in the future. The negative equity can be rolled into another loan, however, this raises the likelihood of becoming underwater again.
What Are the Reasons You End Up With an Upside-Down Car Loan?
One might be “underwater” on a car loan in a number of ways. Some, like depreciation, can be difficult to manage, while others call for restrained purchasing practices to avoid wasteful blunders.
- The rapid depreciation of your car. Once a new car is driven away from a dealership, its value typically drops rapidly. There is a steep decline in value over the first few years of ownership, which eventually levels off. The interest portion of another car loan is typically much more than the principal portion at the beginning of the term. When taken together, these factors make it challenging for borrowers to make up for depreciation and build equity in the first few years of a loan. The market could alter even if you acquired a car that is known to retain its worth well. Your car payments may fall behind the vehicle’s diminishing value if the depreciation is too great. The value of your model may drop, for instance, if a widespread issue appears with it. In a similar vein, if a car manufacturer sells thousands of identical automobiles to rental car companies, the resale price of your car will plummet.
- A sufficient amount of money wasn’t provided for the initial down payment. It’s not unusual for someone to purchase an automobile, either new or old, with no down payment and no trade-in. If you do this, especially if you’re getting a loan to buy a brand-new car, you’ll be in serious financial trouble the second you drive off the lot. Unless it’s a classic, the value of a car drops over time. Early payments on a normal auto loan rarely keep pace with the significant depreciation of the vehicle as it ages on the road.
- The term of the car loan is way too long. Consumers are stretching out their loan terms longer and longer to cover the ever-increasing costs of buying an automobile, new or secondhand. In order to get a car loan with a manageable monthly payment, you can extend the term to six to eight years. A negative side effect is that it can prevent your payments from keeping pace with the value of your home as it declines in value.
- Unreasonable cost of borrowing funds. An increased rate of interest on a car loan means that a larger portion of your monthly payment will go toward interest. Early on in a new loan, the disparity is greatest, and it also happens to be when most new cars lose the most value. Interest rates on loans for used automobiles are typically higher than those for new ones, making it difficult to catch up with even the slower depreciation that comes with buying a used car.
- Costly add-ons or financing fees. You raise the probability of being upside-down on your car loan any time you make a payment that does not improve the worth of the car. The resale value of an automobile is not much improved by most dealer add-ons. Their added value is unlikely to justify the interest and principal payments required to acquire them. It’s not uncommon for hidden fees and add-ons to make their way into the final bill. Read any sales paperwork carefully to ensure you are receiving the exact terms you agreed to.
How to Determine Whether Your Car Loan is Upside-Down?
In some cases, being upside-down on a car loan can be beneficial, but it’s still important to be aware of where you stand. In three easy steps, you can find out whether you have negative equity:
Step 1: Call your lender and ask for a payoff estimate. All of the money you owe on your car, including interest, will be detailed in a payback quotation.
Step 2: Determine the current market value of your vehicle. If you want to get a ballpark figure for how much your automobile is worth, Kelley Blue Book has a handy calculator you can use. However, if sold privately, the vehicle may fetch a much higher price. To get an idea of what you might be able to sell it for, you can also get trade-in quotations from local dealers.
Step 3: Check your math. The equity of your vehicle is the difference between the current market price and the amount still owed on your loan. If the outcome is negative, then you are in the negative equity position of your car loan.
How to Get Out of an Upside-Down Car Loan
If you’re in the negative, you can choose a few different routes.
- It’s time to settle up. Pay off the loan completely if you intend to keep the car. After paying off your auto loan, any remaining equity can be cashed in by selling or trading in your vehicle.
- Obtain a Gap Insurance. If your automobile is totaled, gap insurance will pay the difference between what your insurance provider gives you and what you still owe on the loan.
- Refinance. In order to build equity in your home more quickly, consider refinancing your loan into one with a shorter term or a cheaper interest rate.
- You should make some further payments. If you pay more than required each month and specify that the extra amount is used to the principal of your loan, you will increase your equity much more quickly.
How to Avoid an Upside-Down Car Loan
If you are not yet upside down on your auto loan but are considering a new vehicle purchase, there are steps you can take to make it less likely that you will end yourself in that position. What’s the most important factor? Prepay if at all possible.
- Put up some sort of initial deposit. It is possible to avoid owing more on an automobile than it is worth by making a down payment of at least 20 percent. Make use of the money you save through trade-ins and manufacturer rebates.
- Don’t avoid paying the taxes and fees; just pay them. Borrowing greater than the car’s value leads to “being upside down,” also known as adding taxes and fees to your loan. Put that money into a down payment instead.
- Pick a repayment period that works best for you. If possible, get a loan with a term that matches how long you want to retain the car. This lessens the overall price and keeps you from having to make payments when the value of your car declines.
- Make sure you get a car with low depreciation. There are automobiles that are better investments than others. You can use the estimated depreciation provided by sources such as Kelley Blue Book as well as Edmunds.
Final Thoughts
“Upside down” refers to a situation in which a person has a greater debt relative to the value of an asset. It is possible to either stay out of it or escape from it. This is especially probable at the beginning of your loan term. While hanging upside down can be uncomfortable, there are ways to minimize the time spent in this position. By increasing your down payment or monthly payments or by refinancing, you can get out from underwater and into positive equity. To better plan your finances, you should look at an amortization schedule to determine when you will have achieved positive equity.
