What Is an Upside Down Car Loan?
If you have an upside down car loan, you owe more money on the loan than your car is worth. If you sell your car while your loan is upside down, you'll have shortfall known as "negative equity." When that happens, you won't be able pay off the remaining portion of your car loan.
- Alternate names: Negative equity car loan, underwater car loan
Suppose you use a car loan to buy a car. You don't have enough to pay the taxes and fees included in the purchase, so you include them in your loan. This makes your loan more than the value of the car, so you're upside down from the beginning.
How an Upside Down Car Loan Works
Anytime you owe more on your car than it is worth, your loan is considered upside down. Here are some of the more common situations when an auto loan can become upside down.
Your new car is a depreciating asset; it takes you where you need to go, but it undergoes irreparable wear and tear in the process. In fact, a new vehicle usually loses 20% of its value in the first year of ownership, and 60% of its value within five years.
Couple the speedy depreciation of a car with a high original loan amount relative to the car's value—meaning you paid more for it than you should have—and you can easily find yourself upside down on your car loan.
Trading in a car you owe money on doesn't absolve you of your responsibility to repay the remaining debt.
Suppose you get an auto loan to finance a new car with a price tag of $30,000. After one year, your car might be worth only $24,000; after five years, it could be worth just $12,000. Suppose you have only paid back $16,000 of the $30,000 you borrowed after five years. You'd still owe $14,000, which means you'd be upside down on your loan, with $2,000 in negative equity. If you want to trade in the car, you'd still have to repay that $2,000.
Extra Wear and Tear
Abnormal wear and tear can cause a vehicle to depreciate even faster. For example, if you buy a brand new Jeep and do lots of off-road driving, you might wear it down sooner that is normal. It's value could be much less than you'd hoped when you decide to trade it in for a newer model, leaving you to roll the rest of your loan to your new Jeep.
If you're in an accident, and your vehicle is totaled, your car insurance company may declare the vehicle a total loss and pay you its "book value" or fair market value. As you would you owe more money on the car loan than its value, you'd be stuck paying back a loan for a vehicle that doesn't exist anymore.
Many people become upside down in their auto loans by trading in their cars too early. This happens when a trade-in is done before the loan is at a point where the vehicle's trade-in value is more than the remaining balance on the loan. The remainder must be paid off or rolled into the next loan, which causes you to be upside down from the beginning.
If you opt to trade in one financed car for another one, carefully review the terms of the loan contract. Don't sign it until you understand exactly how the negative equity will factor into the new loan, as well as what your monthly payment and total cost of the loan will be.
How to Trade In a Car With an Upside Down Loan
If you're fed up with a car you're upside down on and want to trade it in for another, you only have a few options:
- Delay the trade-in: Postpone the trade-in until you've paid back enough of your loan to reach a favorable equity position (i.e., when you owe less than the car is worth). This option will enable you to take out a new loan that corresponds with the actual price of the vehicle, keeping the cost of your loan down and preventing another upside down car loan.
- Roll the balance from the old loan into the new loan: Your monthly payments, interest costs, and total costs on the new loan would be higher with the negative equity factored in than if you'd paid the balance first. If the new loan doesn't cover the full balance of the old loan, you could be on the hook for two monthly car payments on two different loans.
- Find a dealer who's willing to pay the balance: Car dealers may offer you a deal to get your business, but if you take it, get the dealer's commitment in the contract to exclude the negative equity from the new financing agreement. Otherwise, some dealers may offer to pay off the balance of an upside down car loan but later include it in the new loan or subtract it from your down payment.
How to Avoid an Upside Down Car Loan
Fortunately, being underwater on a car loan is easy to prevent if you adopt some general principles:
- Make a substantial down payment: The best way to maintain a favorable equity position on your car loan is to make a substantial down payment of at least 20% on any vehicle you purchase. That will keep your loan amount (and, consequently, your monthly payment and total loan costs) low so that you can pay off the loan more quickly. For a $30,000 vehicle, plan to put down at least $6,000 to stay above water.
- Choose a shorter loan term: The sooner you pay back your car loan, the less likely you will be to go underwater on a car loan. The longer you drag it out, the greater the difference in potential depreciation and value will be. In general, choose the fastest repayment period possible. A 36-month loan is preferable to a 60-month loan, which is preferable to an 84-month loan. While a higher monthly payment may seem like a burden, it's worth the financial peace of mind if you can afford it.
- Buy within your means: The best way to avoid an upside down car loan is to set a budget for your car and stick to it when car shopping. One good rule of thumb is the 20/4/10 principle. Put 20% down, choose a loan term of four years, and ensure that your monthly vehicle costs (including loan payments, insurance, and maintenance) represent no more than 10% of your gross monthly income. For example, if you make $50,000 a year, set aside a down payment of $10,000, and are willing to agree to a 48-month loan, you can reasonably afford a car with total monthly costs of up to $417.
- Try to sell your car at higher than the market value: Although the simplest way to avoid an upside down car loan is to keep your loan balance low, you can also try to sell your vehicle through a private sale to a buyer who is willing to pay more than the market value, ideally at the wholesale price. Contact your lender for the car loan before the sale to get their sign-off.
- An upside down car loan is a loan with a balance that exceeds the car's value, resulting in negative equity.
- You'll have to pay off the negative equity if you want to trade in a car you still owe money on.
- It's better to pay off negative equity before you trade in the car, but you can also roll the balance into a new loan or find a dealer who is willing to pay it off for you.
- You can avoid becoming upside down on your car loan if you take out one you can afford and seek one with a shorter term.