An upside-down loan is a situation where the amount you owe is more than your car or home's market value. This often happens when the item loses value faster than the loan balance decreases. How exactly does that happen, and what can you do about it?
How the Numbers Worked Out
Loans are paid off over time. Generally, each monthly payment goes partly towards interest costs and partly towards reducing the 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 get to zero before the item’s value does.
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 the loan, you have an upside-down loan. You’ll have to write a check to sell the thing or keep paying for it after it’s 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, you generally want 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 towards the end of your loan.
Upside Down Home Loans
Upside down loans on houses are more complicated because you might expect houses to increase in value over long periods of time (automobiles lose value due to depreciation pretty much immediately after you buy them). However, the subprime 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.
Price movement isn't the only risk: certain types of mortgages can pull you underwater because your loan balance increases over time.
Options for Upside Down Loans
If you find your loan upside down, 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. If you take this route, investigate gap insurance 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 the loan, so you'll have to come up with 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 also stop the bleeding by working with your lender. Discuss your options with your lender and with a local bank or credit union. One approach might be to sell your car and create a new loan for any unpaid balance. This might require a voluntary repossession. You won't have a car, but you will 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. Or, you could try leasing a car instead.
Roll the Debt
A tempting option, which gets used more than it should, is to sweep the debt 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 generally unwise. You'll end up with higher monthly payments and you'll pay more interest than you need to.