Upside-Down Car Loans
Due to wear and tear, a decline in demand, and becoming obsolete, most vehicles depreciate in value over time. This means they become less valuable as they age and become negative equity.
Unfortunately, when vehicles become less valuable faster than their owners can pay off the car loans, the owners usually are faced with upside-down car loans.
Being upside down on a car loan presents a number of problems, but there are ways to get above water.
What Is an Upside-Down Car Loan?
An upside-down car loan, also known as an “under water car loan” or “being under water,” means you currently owe more on your auto loan than the vehicle is actually worth.
Aside from failing to pay off the car loan as quickly as the vehicle depreciates, many factors can lead to under water auto loans including (but not limited to) buyers taking advantage of:
- Dealership and manufacturer incentives.
- Low interest rates.
- Long-term loans.
- Smaller down payments.
- Roll-over loans.
Such factors can lead to car buyers over-extending themselves, because they promise instant gratification and cloud the buyer's vision of the future of the vehicle and car loan.
Is My Car Loan Upside-Down?
The simplest way to find out if you're under water on your auto loan is to check the trade-in value on your vehicle. Perhaps the most popular tool for this is the Kelley Blue Book (KBB), which allows you to check your vehicle's value based on factors such as the year, make, model, and mileage.
If your vehicle's value is worth less than what you owe on your car loan, your auto loan is under water.
Problems with an Upside-Down Car Loan
Perhaps the biggest problem of having an upside down car loan involves your car insurance.
Generally, if you total your vehicle (which typically means the cost to repair the vehicle is more than the vehicle's actual cash value), your insurance company will only pay the fair market value of your vehicle at the time of the crash. This is a problem because the fair market value likely is less than what you still owe on your car loan, meaning you still have a car loan to pay off.
One way to prevent this problem is to purchase GAP insurance, which will cover the financial difference. See Purchase GAP Insurance below for details.
Selling or Trading Your Vehicle
It isn't rare for people to want to sell or trade in their cars before the auto loan is completely paid off. If you are above water on your car loan, you'll have no problem doing this. However, if you are upside down on your car loan, selling or trading in your car becomes problematic.
Unless you have enough cash set aside, you'll probably have to give any money you get for your car right to your lender, AND you'll still have to pay the remainder of what you owe.
How to Get Above Water
Fortunately, there are several ways you can get above water on your car loan; however, they do come with risks. Always weigh the pros and cons of getting out of an upside-down car loan before taking action.
Keep Your Current Vehicle
Consider keeping your current vehicle until you break even on the loan; at this point, you can trade in your vehicle for a newer one without having any negative equity.
However, this might not be a viable option if your current car is in major disrepair and you're desperately in need of a new vehicle.
Purchase GAP Insurance
GAP insurance, or “guaranteed auto protection,” protects your finances in the event you total your car and the insurance company will only pay what it's worth. If you have GAP insurance, the insurance company will also pay the difference between what the car is worth and what you still owe on the car loan.
Roll the Balance to a New Car Loan
Because there are no out-of-pocket expenses, this might be the most popular option. The dealership takes what you owe on your current trade-in vehicle and rolls it over to your new auto loan.
The downside to this option is that not only will you have to pay interest on your new car loan, but you'll also have to pay the balance on your old under water vehicle (all rolled into monthly payments); however, some dealer incentives such as rebates could help counteract this extra expense.
After you estimate your current trade-in value, try our auto loan calculator to find out approximately how much you'll need to finance and what your monthly payments will look like.
Find Incentives that Cover Your Debt
Look for dealership and/or manufacturer deals high enough to cover what you currently owe on your trade-in vehicle.
Be aware that vehicles with dealership and manufacturer incentives tend to depreciate faster than other vehicles; still, this option might be more attractive than rolling the balance to a new car loan, because the dealership or manufacturer has absorbed the negative equity. Your new monthly payments won't reflect what you still owe on the old vehicle.
Refinance with a Short-Term Loan
Consider refinancing your current loan with a shorter-term loan, which can help speed up the time it takes to get your loan above water, or at least break even.
Keep in mind, though, that shorter term loans tend to come with heftier monthly payments, so take care not to take out a loan you can't reasonably afford each month.