Buying a car of any kind is a huge financial responsibility, one that can cause a lot of debt. In fact, a high-cost car can land you an upside-down car loan. This happens when your car loan is costing you more than your car is worth. If you have negative equity in your car, find out what you should do.
What Is An Upside Down Car Loan?
Being upside down on your auto loan means you owe more on your loan than your car is worth. For instance, if your vehicle is currently valued at $8,500 but you still owe $10,000 on your car loan, you’re considered to be upside down on your loan.
In this particular example, you’d be upside down by $2,500. That means if you sold your vehicle for $8,000, you’d still owe your lender the remaining balance of your loan, which in this case is $2,500.
Otherwise referred to as being “underwater” on your loan or having negative equity, an outstanding loan balance that’s higher than your vehicle’s current value can put you in a predicament, especially if you ever want to sell your car in the future.
Compare this to positive equity, which means your car is worth more than what you still owe on your car loan. For example, if your car is currently valued at $8,500 and you have an outstanding car loan balance of $4,000, then you would have $3,500 in positive equity. If you sold your car for what it’s worth, you would profit $3,500.
Risks Of Being In An Upside Down Car Loan
You may be fine if you have an upside-down car loan, as long as you continue making payments. But any number of things can pop up that can put you in a vulnerable position if you carry negative equity, including the following:
You’ll Owe Your Lender More If You’re In An Accident
If you’re involved in a collision that results in your car being totalled, your insurance provider will pay out the current value of your vehicle. That means, if your loan amount is more than what your car is worth, you’ll end up owing your lender the difference between your outstanding loan balance and the insurer’s payout (your car value). If you don’t have access to the cash needed to pay your lender, you could find yourself in a financial predicament.
You Won’t Profit If You Sell
If you need a different type of vehicle for whatever reason, you’ll want to sell your current car and trade it in for something that suits you better. For example, if you were driving a small sedan, you may need a larger vehicle to accommodate a growing family.
If you sell your car with an upside down car loan, you’ll only get what it’s worth. That means you’ll still have to pay the difference between the loan balance and the amount you sell your car.
You’ll Owe Money Even If Your Car Is Repossessed
If you find yourself unable to continue making your car loan payments, you may have no choice but to sell your car or have it repossessed. For instance, you may be laid off, have your hours cut, or become unable to work due to disability. If you’re forced to sell your vehicle or have it repossessed because your income has taken a dive, you’ll again be left owing your lender some money.
What Causes Your Car Loan To Become More Than Your Car Is Worth?
There are a few reasons you may end up with an upside down car loan.
Low Down Payments
When purchasing a vehicle from a dealership, drivers also have the option of making a down payment in order to pay for it more quickly. However, if they choose not to or don’t make one that’s large enough, their regular car payments may not be big enough to keep up with the depreciation of the car.
How Much Should You Put Down On A Car?
While 20% is usually the suggested down payment, it should be, at the very least, large enough to cover the cost of the vehicle’s immediate depreciation. Let’s say the car costs $30,000 but lost 11% of its value after you left the lot. So, your down payment should be at least $3,300, more if possible to reduce your payment period.
Negative equity can also happen if your interest rate is too high. This can happen if your credit score was unfavourable or your financial situation is too risky to qualify for a more reasonable rate. High interest means it’ll take higher payments to cover more of the car’s principal balance. If your loan term is extended due to a high-interest rate, your payments may not be able to reduce your loan balance faster than the depreciation rate.
Buying More Than You Can Afford
With car financing options ranging up to 84 months, borrowers may be buying cars they wouldn’t have been able to afford initially. The longer the car term, the higher the chance you’ll end up in an upside-down car loan. This is because the car will continue to lose value as you make the same loan payments over several years.
How To Find Out If You Have An Upside-Down Loan?
To find out if you’re upside down on your car loan, you’ll need two pieces of information: your vehicle’s current value and your outstanding loan balance.
- Find out what your car is worth. You can use sources like Kelley Blue Book to estimate how much your car is currently valued based on its year, make, model, mileage, and condition.
- Find out how much you still owe. Reach out to your lender or check the most recent loan statement to find out what your outstanding loan balance is.
- Subtract the loan balance from your car’s current value. If the result is negative, then you’re upside down on your loan. The answer you get from the equation will tell you exactly how much negative equity you have.
What Should You Do If Your Car Loan Is More Than Your Car Is Worth?
Whether you financed your car with a car loan or personal loan, if your loan is higher than what your car is worth, it is upside down. If that’s the case, there are a few things you can do to at least minimize your debt and get out from under it faster than you would by leaving it to chance.
Refinance Your Car
You can reduce your outstanding car loan by paying it off sooner. To do that, you can refinance your current car loan, which essentially involves taking out a new car loan to replace your existing one. Ideally, you’ll refinance with a lower interest rate and more favourable terms, especially if your credit score has improved. With a lower rate, you’ll owe less in interest, which will reduce your overall loan amount.
You can also choose to refinance your loan with a shorter loan term. This will increase your monthly payments, but it will also help you pay your loan off sooner. Either way, refinancing can help you get out of an underwater car loan and get you back into positive equity territory.
Make Extra Payments
If you have the financial means, consider making extra loan payments. Many lenders allow borrowers to make one extra lump sum payment per year toward paying down their loans more quickly. Not only will this help you work toward having positive equity in your car, but it will also help you pay your loan off faster since these extra payments go toward the principal portion of the loan.
Keep in mind that some lenders charge an early repayment penalty fee for paying off your loan before the original term expires. Find out if your lender charges this fee, and how much it is. Then, crunch the numbers to make sure these charges don’t cancel out any savings from repaying your loan early.
Consider Trading Down
While it might pain you to do so, trading your vehicle in for something more reasonably priced could save you a lot of stress down the road. You can bring your vehicle back to the dealership, trade it in for an older model or something more used. True, you will likely be taking a significant loss from what you initially paid, but your monthly payments and insurance rate will likely be much lower. With a cheaper car, you’ll be able to afford a shorter loan term which can help with creating positive equity.
How To Avoid Getting In An Upside Down Loan?
The best way of getting out of an upside down car loan is to avoid getting into one in the first place. Follow these tips to prevent being underwater on your loan:
Buy A Used Vehicle
Buying a new car and financing it with a very long loan term can put you at risk of becoming upside down on your loan. New cars depreciate the moment you drive off the dealer’s lot and decline in value faster than used cars. Instead, used vehicles depreciate at a much slower rate.
Consider buying second-hand to reduce your odds of finding yourself underwater on your loan and to reduce the amount you have to borrow.
With a car lease, you don’t actually own the vehicle. Instead, leasing is somewhat like long-term renting. At the end of your lease, the car won’t be your responsibility anymore, so you won’t have to worry about becoming upside down on a loan.
Plus, leasing allows you to have a newer vehicle every few years without having to worry much about maintenance and repairs.
Make A Larger Down Payment
You can lower the overall amount you have to borrow by making a down payment of at least 20%. The less you owe, the lower the odds of ending up with an upside down car loan.
Choose A Shorter Loan Term
A shorter term might mean higher installment payments, but it also helps you keep up with the car’s depreciation rate. Plus, you’ll pay your loan off sooner, which means less spent on interest.
Buy GAP Insurance
A Guaranteed Auto Protection (GAP) plan protects you if you have negative equity and your car is totalled in an accident while you still owe a balance on your car loan.
When it comes down to it, you will pretty much always end up paying more than a car itself is worth, especially if the car is new or only gently used. This is mostly due to the interest payments associated with all forms of financing. Dealerships and other lenders need to charge interest for their products, otherwise, they wouldn’t be making a profit. When buying a dealership car, you’re not only paying the initial price tag, you’re paying interest on top of it. Therefore, no matter what shape the car is in or how quickly you manage to pay it off, you’re still paying more than the car is worth. The key, however, is to determine just how much more you’ll end up paying and try to reduce that price as much as possible before you sign any contracts.