An upside-down loan is a loan balance that's higher than the value of your car or home's market value. In other words, you owe more than you own. This often happens when something you buy with debt loses value faster than the loan balance decreases.
How the Numbers Work
You pay most loans off over time. That's particularly true for standard home and auto loans. A portion of each monthly payment goes toward interest costs, and the remainder reduces your loan balance. Eventually, you pay off the loan balance entirely. This process is called amortization.
With an amortizing loan, you want the loan balance to reach zero before your asset loses a substantial amount of value.
How Loans Get Upside Down
Loans go upside down when the item you buy loses value faster than the loan balance decreases. For example, a brand new car might cost $25,000. A few years later, it might only be worth $15,000. If you owe more than $15,000 on your auto loan, you have an upside-down loan. You’ll have to write a check to sell the vehicle, or you'll need to keep paying on the loan after the car is worthless.
To avoid that problem, you need to pay down the loan (or have it amortize) faster than the item loses value. For auto loans, it's best to use loans that last less than five years. Longer terms—like six and seven-year loans—can help keep monthly payments low, but you risk being upside down toward the end of your loan.
Upside Down Home Loans
Upside down loans on houses are complicated because you might expect house prices to rise over long periods of time. Automobiles, on the other hand, lose value due to depreciation almost immediately after you buy them. However, the subprime lending debacle starting in 2007 showed that falling home prices are a very real risk. In the real estate world, sometimes the term "underwater" or "negative equity" is used instead of upside down.
But price movement isn't the only risk: Certain types of mortgages can pull you underwater because your loan balance increases over time. When you don't pay enough each month to cover the interest charges on your loan, those costs can be added to your loan balance.
Options for Upside Down Loans
If you find yourself in an upside-down loan, you've got difficult decisions to make.
Ride It Out
One option is to keep your car or home and continue paying on the loan. Unfortunately, that's not always feasible. Expensive repairs can make a vehicle more trouble than it's worth, and you might need to relocate and sell your house for a variety of reasons. If you take this route, investigate gap insurance for automobiles to manage your risk.
Sell (And Pay)
Another option is to sell—just to put an end to things. The bad news is that selling won't bring in enough money to pay off your loan, so you'll have to come up with the remaining cash on your own. If you're selling a car, it might be best to sell it yourself, as you can often get higher prices from private buyers than you'll get from a dealership.
Work It Out
You can potentially stop the bleeding by working with your lender. Discuss your situation with your lender and with a local bank or credit union. One option might be to sell your car and pay off the remaining balance over time, which might involve voluntary repossession. You won't have a car, but you may have lower monthly payments and lower interest costs going forward. Combine this with the purchase of an inexpensive used car, and you might be on your way to standing on solid financial ground.
Find out how your credit scores might be affected by any options you're considering.
Roll the Debt
A tempting option, which gets used more than it should, is to sweep the debt problem under the carpet. Head over to a dealership, and explain your situation. You can trade-in your existing vehicle for a new one, and add any unpaid loan balance to your new car loan. Of course, then you're paying for your new car and your old car every month—which is not sustainable over the long term. Plus, you'll end up with a high monthly payment, and you'll probably pay more interest than you need to.