Unlike houses and other assets, such as fine art collections, which may appreciate over time, new cars begin depreciating the moment you drive them off the lot. If your car depreciates faster than you can pay down the loan, you may find yourself with an upside-down car loan.
While this can be a challenging financial hurdle and an undesirable position to be in, it’s not an irreversible situation. With a solid understanding of the nature of an upside-down loan, the reasons behind its occurrence, and effective strategies to manage it, you can confidently turn the tide in your favor.
What is an upside-down car loan?
An upside-down car loan, often referred to as an underwater car loan or negative equity situation, occurs when your remaining loan balance is more than the current market value of your car. That means if you were to sell your car today, you wouldn’t earn enough money to pay off your existing loan.
Several factors contribute to this dilemma, incuding the steep depreciation that new cars experience. The moment you drive your new car off the lot, it can lose up to 20% of its value, and by the end of the first year, it might depreciate by 30%.
If you’ve taken a new car loan with a small down payment and stretched out your loan term to make your monthly payments more manageable, your loan balance can easily exceed the value of your car.
This is growing more common as the cost of new cars has hit record highs and people are taking out 84-month loans to make their monthly payments on a new vehicle more affordable.
Rolling over any remaining balance from a previous auto loan into a new loan or high interest rates due to bad credit, can also lead to an upside-down loan.
How to Determine If Your Car Loan Is Upside-Down
To find out if your car loan is upside-down, you need to compare the current outstanding balance on your loan with the present market value of your car. Here are the steps:
Find Your Current Loan Balance
Your current loan balance is the amount you still owe on your car loan. You can obtain this information from your most recent loan statement, on the website where you pay your car loan, or you can contact your lender directly.
Determine the Current Value of Your Car
Next, you need to find the current value of your car. You can use online resources like Kelley Blue Book or the National Automobile Dealers Association to get an estimate. Remember, the value of your car will depend on factors like its age, make, model, mileage, and overall condition.
Compare the Two Values
Once you have these two numbers, compare them. If your remaining loan balance is higher than the current value of your car, you are in an upside-down car loan situation.
It’s important to understand that being in an upside-down car loan situation is not uncommon, especially in the early years of a car loan when car depreciation is highest. However, by being aware of your financial situation, you can make informed decisions to manage and potentially rectify the situation.
The Risks of an Upside-Down Car Loan
Being in an upside-down car loan situation can pose a few challenges. If your car gets totaled or stolen, your insurance settlement may not cover the full loan balance. Consequently, you’ll still owe your lender the difference, which could be a sizable sum.
Having negative equity can also hinder your ability to trade in your car for a new one. Dealers may roll the remaining balance of the old loan into the new loan, which could result in higher monthly payments or even more debt.
The situation can create significant financial stress and complicate future financial decisions. But it’s essential not to panic. There are a few options to handle an upside-down car loan.
5 Strategies to Get Out of an Upside-Down Car Loan
1. Keep Paying the Loan
The most straightforward approach to managing an upside-down car loan is simply to continue with the monthly payments until the loan is fully paid off. If you’re in a position to comfortably manage the payments and have plans to retain the car for an extended period, this strategy might work well for you. As you persist with payments, your principal balance will gradually decrease, slowly building positive equity in your car.
However, patience is key here, as it may take several years to correct the upside-down situation, especially if your loan term is lengthy.
2. Refinance the Loan
If your initial loan had a high interest rate and your credit scores have since improved, you might want to consider refinancing. Refinancing involves replacing your existing loan with a new one, ideally at a lower interest rate. This approach can potentially decrease your monthly payments, thereby helping you save money.
Remember, refinancing to a loan with a longer term can reduce your monthly payment. However, it could also mean you stay in an upside-down position for longer. This is because you’ll be paying off your loan balance more slowly.
3. Sell the Car and Pay Off the Loan
Should your car’s value according to Kelley Blue Book or National Automobile Dealers Association be in close proximity to your loan balance, selling your car might prove to be an effective solution to counter the negative equity. A private sale frequently yields more money than a dealership trade-in. You could potentially fetch a decent price that covers a major part, if not all, of your remaining loan balance.
Remember, if the sale of your car doesn’t cover the entire loan balance, you’ll have to cover the difference. This may require using savings or acquiring a small unsecured loan, such as a personal loan.
4. Consider Voluntary Repossession or Bankruptcy
In severe situations where the loan has become completely unmanageable, you might contemplate voluntary surrender or bankruptcy. However, both these options will drastically impact your credit scores and should only be considered as last-resort measures.
5. Utilize Gap Insurance
Guaranteed Asset Protection, or gap insurance, serves to protect you financially by covering the difference between your remaining loan balance and your car’s value in the event of a total loss. While it won’t aid in paying off an upside-down car loan directly, it can offer peace of mind and prevent the situation from worsening in case of unforeseen incidents involving your car.
How to Prevent Upside-Down Car Loans in the Future
The best approach to dealing with an upside-down car loan is to prevent its occurrence altogether. Below are some preventative strategies:
Make a Larger Down Payment
Making a large down payment can significantly reduce the amount you need to borrow, and it gives you a head start on building equity in your car. This can create a buffer against rapid car depreciation and other factors that contribute to negative equity.
Go for Short Loan Terms
Opting for a shorter loan term might result in higher monthly payments, but it also means you’ll pay off your loan more quickly. Paying off your loan faster reduces the likelihood that the value of your car will fall below your remaining loan balance, thus helping avoid an upside-down loan scenario.
Make Extra Payments
If your budget permits, consider making extra payments on your loan. By reducing your principal balance faster, you can exit a negative equity situation sooner. Even a small additional amount each month can make a noticeable difference over time.
Consider the Value of Used Cars
Buying a used car is another viable strategy to avoid upside-down car loans. Used cars have already weathered the most significant depreciation period, which typically occurs in the first few years. Therefore, a used car is less likely to drop in value faster than you can pay off your loan.
Choose an Affordable Loan Agreement
Avoid the temptation of getting a more expensive car with a lengthy loan term simply to keep the monthly payment within your budget. A more expensive car can depreciate rapidly, increasing the risk of finding yourself in an upside-down loan. Choose a loan agreement that fits comfortably within your financial capacity to ensure manageable payments.
Regularly Monitor Your Car’s Value
Stay informed about your car’s value by regularly consulting reliable sources such as the Kelley Blue Book or the National Automobile Dealers Association guide. Keeping up-to-date with your car’s current market value can help you assess your equity situation and make informed financial decisions.
Maintain Your Car in Good Condition
Keeping your car in good condition can help maintain its value over time. Regular maintenance and proper care not only ensure your car performs efficiently but can also prevent the car’s value from dropping significantly, thus reducing the risk of an upside-down car loan situation.
With a solid plan and a disciplined approach, it’s possible to navigate your way out of negative equity. Review your financial situation, consider your options, and choose the best course of action for you. Always remember, the decisions you make today will impact your personal finance tomorrow. So, make wise and informed choices.
Frequently Asked Questions
Does an upside-down car loan impact my credit score?
While being upside-down on your car loan doesn’t directly affect your credit score, if it leads to financial stress causing you to miss payments, your credit score can be negatively impacted. Making timely loan payments is a crucial component in the calculation of your credit score.
Does gap insurance cover negative equity?
Gap insurance covers the difference between your car’s current market value and your remaining loan balance if your car is totaled or stolen. However, it doesn’t cover the negative equity in your loan under regular circumstances.
What happens if I total my car while having an upside-down car loan?
If you total your car while having an upside-down loan, your car insurance will typically pay out the car’s current market value. If that amount is less than your loan balance, you’re responsible for paying the difference unless you have gap insurance.
What are the implications of an upside-down car loan if I want to lease my next car?
Leasing a car while having an upside-down car loan can be challenging. Some lenders might allow you to roll the negative equity into the lease agreement, but this will increase your monthly payments and could lead to you being upside-down in your lease.
Can I trade in my car if I have an upside-down loan?
Yes, you can trade in your car even if you’re upside-down on your loan. However, remember that the amount you still owe doesn’t disappear. The remaining loan balance, or the “negative equity,” will typically be rolled into your new loan agreement. This could lead to an even larger upside-down loan for your next car.
Can I get out of an upside-down car loan by selling my car privately?
Yes, selling your car privately could help you get more for your vehicle than trading it in at a dealership, possibly enough to cover your remaining loan balance. However, if the selling price doesn’t cover the entire balance, you’ll be responsible for paying the remaining debt, which could involve using savings or taking out a small personal loan.