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 can do to your finances.

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Being upside down on a car loan happens when you owe more than your vehicle is worth, which also is called negative equity.

Don’t think it can’t happen to you. It probably already has. Industry experts acknowledge that automobiles lose 20% of their value as soon as you drive off the lot.

That 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. Depending on how much you put down to buy it, you may already owe more than the car is worth.

The average price for a new car in 2021 was $40,857, according to Kelley Blue Book. The average loan was $35,228, according to Experian. That means on an average-priced new vehicle, you need a down payment of more than $7,000 to avoid driving off the lot with negative equity.

If that happens and you try to sell your car, the sales price probably won’t cover your auto loan. Likewise, if you total the vehicle in an accident, most insurance will only pay for the value of the car regardless of how much you owe. That will make it more difficult for you to replace the vehicle.

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

How You Get Upside-Down on a Car Loan

Let’s face it: Getting a new car is exciting. Unfortunately, excitement and calm, rational analysis don’t always go hand-in-hand. That can result in an upside-down car loan a variety of ways.

  • 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 loans: 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.
  • Long-term loans: Terms of 72 and even 84 months have become common, and they allow you to keep monthly payments manageable. But if you’re still paying for a car that is five years old or older, your payments can’t keep pace with the depreciation.
  • Roll over loans: 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.
  • 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.
  • Overly expensive car: Buying a car that stretches you to the limit of what you can afford to pay each month only works if there are no bumps in the financial road. You can’t forget your other obligations like housing, food, student loans and other necessities.
  • High-interest loans: It’s always a good idea to have your financing planned before you go to the car lot. You may negotiate what seems like a good price, but dealer financing may be at a high interest rate.

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?

The good news is unless you’ve totaled the car in a wreck or you absolutely have to sell it in a hurry, there are viable strategies for overcoming the upside-down car loan situation.

Continue Making Payments

The best way out is to keep the car 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. This requires time and patience. If you have a lot of negative equity, look into buying gap insurance to cover the difference between an insurance settlement and what you owe on the loan.

Make as Many Payments as Possible

One more choice to escape from the negative equity position is to pay extra money each month toward the loan principal. This allows you to pay off the loan quicker and build equity at a faster rate. Before you do, check whether your loan agreement adds a fee if you pay it off early.

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 on your next car and not many banks want to make loans to consumers who have no down payment.

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 a 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 when you compare interest rates.

It also 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 is an 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.

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 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 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.

If you have bad credit and need a loan, shop for a personal loan with online lenders or try to get a home equity loan. These options may offer lower interest rates than a dealership.

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.

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.”

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. If you need to file for bankruptcy, but want to keep your car, there are options.

About The Author

Bill Fay

Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].


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