An upside-down car loan is one with a loan balance that exceeds the value of the car.
Understand how you can wind up upside-down on your car loan, the impact when trading in your car, and ways to avoid this scenario.
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 in such a scenario, the proceeds won't cover the loan balance, leaving a shortfall known as "negative equity."
Being upside-down or "underwater" on a car loan can put you in a financial pinch when you trade in your vehicle to buy another car, as you'll need to pay off the negative equity to keep it from being rolled into the new car loan.
How an Upside-Down Car Loan Works
Unlike an investment, 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 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, and you can easily find yourself upside-down on your car loan.
For example, suppose you get an auto loan to finance a new car with a price tag of $30,000. After one year, your car is worth only $24,000; after five years, it will be worth just $12,000. Now, let's say that you 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 through one method or the other.
Moreover, 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.
Trading in a car you owe money on doesn't absolve you of your responsibility to repay the remaining debt.
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 have three options:
- Delay the trade-in: Postpone the trade-in until you've paid back enough of your loan to reach a position of positive equity (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 car, keeping your loan costs low and avoiding an 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 had you paid off the balance first. Your new loan would also exceed the price of your new car from the start of your ownership tenure, increasing the likelihood that you will become upside-down on the new car loan. And 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 such 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, dishonest 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.
If you opt to trade in a car you still owe money on for another car financed through a loan, 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 loan costs will be.
How to Avoid an Upside-Down Car Loan
Thankfully, being underwater on a car loan is easy to prevent if you adopt these general principles:
- Make a substantial down payment: The best way to maintain a position of positive equity on your car loan is to make a substantial downpayment of at least 20% on any vehicle that you purchase. This 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 faster you pay back your car loan, the less likely you are to go underwater on a car loan. The longer you drag out a car loan, the greater the potential depreciation and shortfall between what you owe and what your car is worth. 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. A 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 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 value of the car, 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 willing to pay it off for you.
- You can avoid becoming upside-down on your car loan if you take out a car you can afford and seek loans with short terms.