What Is An Upside Down Car Loan?

    You are upside-down on a car loan when you owe more than your vehicle is worth. It happens a lot, but there are ways to limit the long-term damage it will do to your finances.

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    Industry experts acknowledge that automobiles lose 20% of their value as soon as you drive off the lot, which means the $25,000 car you just bought, is only worth $20,000 by the time you hit the first traffic light outside the dealership.

    For the people that need to borrow money to purchase a car, that is the definition of being upside down – sometimes referred to as having “negative equity” – on an automobile loan. They owe more than the car is worth as soon as they sign the contract.

    The average price for a new car in 2017 was $35,000 and the average loan was $30,000, meaning consumers are putting down $2,000 less than the 20% suggested for car loans. Using the numbers above, you would need to have a $7,000 down payment on a $35,000 purchase to avoid starting out with negative equity.

    Unfortunately, more and more people make less than a 20% down payment and find themselves upside-down as soon as they buy the car. That is a risky position to be in, especially if you run into a financial crisis and can’t afford payments.

    If you try to sell the car, the sale price won’t cover your auto loan. If you get into an accident, most people’s insurance will only pay for the value of the car and not the total cost of the loan. That means you won’t have any money left over from the insurance to put down on your next vehicle and you still will owe money on the original loan.

    The fact is that increasing numbers of people have car loans that leave them upside-down. In the first quarter of 2017, a record 33% of new car sales were made to people with negative equity who owed an average $5,147 on their loans. The same thing happens at used car lots. Edmunds, an online resource for automotive information, said a record 26% of trade-ins had negative equity averaging $3,854.

    “The best financial move for people is to buy a car and drive it well past the point where you have it paid off,” Jessica Caldwell, senior analyst at Edmunds said. “Unfortunately, the trend is that less and less people are doing that now.”

    In most cases, people who are upside down on an auto loan were too eager to buy a car in the first place. They don’t understand the consequences of the situation until it overwhelms them. It takes great discipline and the ability to work through creative strategies to get out of car debt.

    Using a Car with Negative Equity as Trade-In

    Anyone who has a car radio has heard this advertisement: “We’ll pay off your car loan and put you in a new vehicle …”

    You can fill in the rest of that ad with the name of just about any car and just about any dealership in the U.S. and the promise will be as empty as your bank account because it promises negative equity.

    The ad plays on every station in every market in America and you have to admit it’s enticing enough to make you stop and think about doing it. Someone else bails you out of a bad loan situation and puts you into a new car with no out-of-pocket expense. What’s not to like about that?

    Here’s a word of advice from car-buying experts: DON’T EVEN CONSIDER IT!

    Trading in a car with negative equity to take on another car loan with even more negative equity is like throwing gas on a fire because it’s the only liquid you had handy. You just increased the chances for a serious financial meltdown and here is an example of why.

    Let’s say you owe still owe $10,000 on a car that is only worth $5,000. The dealer will pay off the $5,000 difference, but then roll that amount into the loan on your next car. So, if you needed to borrow $20,000 for the new car, the dealer rolls another $5,000 into the loan to cover the cost of paying off your previous loan and now you’re borrowing $25,000.

    Not only will your monthly payments be higher (and remember, not being able to afford the payments was what got you into trouble to start with), but you likely will be paying higher interest on the loan.

    And, don’t forget, you’re going to add more negative equity to your situation when you calculate the 20% depreciation in value the new car will lose when you drive it off the lot.

    “The idea of austerity, living within your means, doesn’t seem to be as prevalent today as it should be,” Caldwell said.

    “Unless there has been a substantial change in your life circumstances – you’ve started a new construction business and now you need a truck; or you just had triplets and now you really need a mini-van – to have a new car loan and negative equity in your trade-in does not put you in a good place financially.”

    What to know about upside down car loans

    How to Get Out of an Upside-Down Car Loan

    So, what’s the solution when you find yourself upside down on a car loan?

    If you already bought the car, the best way out is to keep what you have and continue paying it off until you own it, or until the loan amount is lower than the value of the car. At least by then, you have equity in the vehicle and will not suffer a financial setback if you decide to sell it.

    If you haven’t bought a car yet, the best idea is turn your back on the new car lot and walk over to the used car lot. There you can find a car that is one-year old and already lost the 20% depreciation that new cars lug out of the lot. That means you should get it for at least 20% less than what you would have paid new and thus avoided the automatic trip to negative equity status.

    Another tactic would be to use savings – money you might have been putting aside for a down payment on a future purchase – to pay off your loan. The downside of that idea is that you no longer have money left for a down payment and not many banks want to make loans to consumers who have no down payment.

    One more choice to escape from the negative equity position is to pay extra money each month toward the loan principal or, if you can afford higher monthly payments, find a loan with a shorter payment term. This allows you to pay off the loan quicker and build equity at a faster rate.

    Refinancing an Upside-Down Loan

    Another option is to refinance the car with a new loan. If interest rates have dropped appreciably since you took out the original loan, the refinancing would allow you to pay off the car faster, or at least get some equity in it. Large bank lenders usually duck when this is proposed, but your community bank or credit union will at least consider the option.

    If you are a homeowner, a more realistic way to refinance would be to get a home-equity loan. That could provide substantial savings. In the summer of 2017, the interest rate on home equity loans for up to $30,000 was 5.2%, which may be less than the rates on most car loans.

    It may be possible to transfer the balance of your car loan to a credit card with a 0% introductory offer. At the end of the introductory period – 12-18 months on most cards – refinance the remaining balance at a credit union or peer-to-peer lender.

    Selling Your Upside Down Vehicle

    If you’re intent on getting rid of your car, and it’s in at least “good” condition, sell it privately rather than trading it in at a dealer. Private sales of cars produce significantly higher return than trade-ins.

    However, there still could be a difference in what you sell the car for and how much you owe on it, so be ready to make up the difference out of your own pocket.

    If you are hopelessly upside down on a vehicle and need relief from that distressing debt, selling the car and taking out a second loan to cover the negative equity could be the best option.

    In short, if you owe $15,000 and your car is worth $10,000, you are $5,000 upside down or have $5,000 in negative equity. If you sold the car for what is was worth ($10,000) and took out a loan to cover the balance, you would be making payments on a $5,000 loan, not a $15,000 loan.

    However, you also would be without a car. This could be a bigger problem if other transit options – bus, subway, carpool, bicycle, walking – are not readily available to get to work, the grocery store, doctor’s office and other necessary stops.

    If you do have easy access to transit and want to sell your upside down auto, the steps are fairly simple. First thing to do is determine your car’s true value. Consult Kelley Blue Book or Edmunds to get an accurate appraisal. Be sure to provide honest information about its condition, mileage and options, all of which affect the resale value.

    Next, call the bank that holds your car loan and ask what the payoff balance is. Now, do the math: Payoff Balance – Car’s Worth = Negative Equity. Using the example above, that would be $15,000 minus $10,000 = $5,000 in negative equity.

    Now comes the hard part: Finding a place that will lend you $5,000 for an unsecured loan! The truth is that you must be a very good customer or have an excellent credit score (or both) to convince a bank or credit union to loan you money in this situation.

    There are other places to find the money – family, friends, credit cards – but at least you’re dealing with a $5,000 loan and not a $15,000 loan and you no longer have the expense of owning a car.

    Once you sell the car, consider using public transportation rather than replacing your car with another one. The combination of bicycling and using the local bus system is a cheap, efficient method for going to work and doing local shopping. The money saved on car maintenance, insurance and gas could help you pay off the remaining balance on your car or go into a savings fund for a larger down payment on the next car you buy.

    Debt-Relief Options to Consider

    If you are too far in debt for these strategies to work and you can no longer pay your monthly bill for the auto loan, consider debt help options. Two of the most commonly utilized options are debt consolidation and debt settlement.

    When you consolidate your debts, your car loan will be combined with other debts in one large loan. The new loan typically comes with lower interest rates and better repayment options.

    In debt settlement, you — or a settlement firm working on your behalf — will negotiate with your creditors to have your balances reduced to a level you can pay it off.

    If your finances are in worse shape, you might consider filing for bankruptcy, a process that can clear all or most of your debts. Find out if this option is right for you by meeting with a credit counselor from a nonprofit credit counseling agency.

    How You Get Upside Down On A Car Loan?

    People are so enthusiastic about buying a new car that when they arrange financing, they don’t account for the fact that the new car loses 20% of its value immediately after purchase.

    Add dealer incentives, smaller down payments and a willingness among lenders to create rollover loans (adding in the negative equity from the previous car to the new car loan) and it’s easy to understand why so many new car owners are under water the minute the minute they get behind the wheel of their new car.

    Some other reasons that people overpay on cars and get upside down on their loans:

    • Inadequate research. Many consumers don’t do enough research on costs for similar makes and models. If the sticker price on a car is $30,000 and similar models are selling for $27,500, you already are upside down on your new car.
    • No money down, long loan terms. These popular incentives sound too good to be true…because they are! Cars depreciate 20% almost immediately and lose 50% of their value by the third year. If you don’t put at least 20% down, you’re upside down right away. If you’re still paying for a car that is five or six years old, your payments can’t keep pace with the depreciation.
    • Unnecessary options. People allow themselves to be talked into costly options they don’t need or won’t use like a sunroof, leather upholstery, DVD player, etc. Not only does that create more debt, it is impossible to recoup the cost of those options when you resell the car.
    • Roll over loan. If you owe money on your old car, the dealer will often offer to roll that negative equity amount into the loan for a new car. This means you are paying two loans at once – the balance on the old car, plus whatever money you’re financing on the new car. In most cases, that means the total financed already is more than the car is worth and you’re upside down again.

    Tips for Avoiding an Upside-Down Car Loan

    It’s best to avoid an upside-down car loan altogether whenever possible. Be diligent with research before you buy a car and understand all the costs of options, financing and taxes so you aren’t already upside down when you drive out the door.

    For most people, that means accepting the fact that you can’t afford to purchase a new car. Instead, look for a late-model used car with low mileage. The original owner will have paid the price for depreciation in the first year, so the purchase price should be at least 20% off the original cost.

    If you are still tempted to buy new, try using the 20-4-10 rule, which means 20% down payment; no more than 4-year loan; and the monthly car payment plus insurance can’t be more than 10% of your gross income. If you can’t make those numbers work, it’s time to go back to the used-car lot.

    The following tips can help you avoid an upside-down auto loan:

    • Choose the shortest repayment plan you can afford. Shorter repayment plans mean lower interest rates and faster payoff. For example, borrowing $25,000 for three years at 6.93 interest (credit score of 675) would result in $2,764 in interest paid. The same deal over four years would cost $3,716 in interest and a five-year loan would be $4,715 in interest. That’s about $1,000 more each year for the same loan. The difference would be magnified even more if your credit score was under 650.
    • Make a down payment of at least 20% of the car’s total cost. This equals the 20% depreciation on the car that happens when you leave the lot.
    • Before you buy, consult Kelley Blue Book and Consumer Reports to estimate the true value of the car. This will keep you from overpaying for the car.
    • Ask about incentives. Dealers may offer enough cash incentives to make up the difference for the 20% depreciation that happens almost immediately when you buy a car.
    • Pay off your car loan before you sell or trade-in. You can’t be upside down on a paid off car.
    • If you know you’ll only keep a car for two or three years, consider leasing instead of buying. A lease means no loan, which means you can’t be upside down.

    One of the few times it’s acceptable to have an upside-down car loan is if you plan to keep your car for many years. You may buy a brand-new car and start off with an upside-down loan, but if you plan to pay down the loan in five years and keep the car for 10 years, you’ll own the car long before it’s time to sell.

    Over the total time you own your car, you’ll be able to convert your negative equity into positive equity, meaning it’ll be worth more than you owe on it.

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    Author

    Bill Fay
    Staff Writer

    Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

    Sources

    1. Carrns, A. (2016, November `8) How to Buy a Car When You Have an Upside-Down Loan. Retrieved from https://www.nytimes.com/2016/11/19/your-money/how-to-buy-a-car-when-you-have-an-upside-down-loan.html
    2. Reed, P. (2015, January 26) Upside Down and Under Water on a Car Loan. Retrieved from https://www.edmunds.com/car-buying/being-upside-down.html
    3. NA, ND. Loan Savings Calculator. Retrieved from http://www.myfico.com/credit-education/calculators/loan-savings-calculator/
    4. NA, ND. FTC Takes Action To Stop Deceptive Car Dealership Ads. Retrieved from https://www.ftc.gov/news-events/press-releases/2012/03/ftc-takes-action-stop-deceptive-car-dealership-ads
    5. Mercadante, K. (2013, February 14) How to Get Out of an Upside Down Car Loan with Negative Equity. Retrieved from http://www.moneycrashers.com/how-to-get-out-of-a-car-loan-when-you-owe-more-than-the-car-is-worth/
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