Whether you call it being upside down on a car loan, being underwater on a car loan, or (more properly) having negative equity in a car loan, this is not a good thing. Let’s break down what you need to know about going upside down on a car loan, how to know if you’re upside down, and how to avoid it.

What is an Upside Down Car Loan?

Being upside down on a loan of any type means that the balance of the loan is greater than the value of the asset securing that loan. In the case of a car loan, that means your car’s value is lower than the balance of your auto loan. You owe more than your car is worth.

👉 For Example

If you have a car that is worth $10,000, but you owe $17,000 on the loan, you’re upside down on that loan. If you sold the car and used all of the proceeds to pay the debt, you’d still owe $7,000 to your lender.

Being upside down on a car loan isn’t a death sentence. If you intend to keep the car for years, you can simply keep paying your loan. You will need additional insurance, which will cost money, but you can do it.

If you ever want to sell your vehicle or trade it in for a new one, being upside down on loan could add complications.

How Do You Wind Up Upside Down on a Car Loan?

Going upside down on a car loan isn’t as unusual as being upside on other types of debt, like a mortgage. There are a few reasons for that.

  • Your Car is Totaled or Stolen – Being totaled means the insurance company will look at the car’s value vs. the cost of repairing it. If the repair cost is the same or more than the vehicle’s value, the insurance company will consider it totaled. So the insurer pays you your car’s current value (based on its estimate). That estimate will not include your negative equity. You have a similar problem if your car is stolen. This insurance check will not cover your negative equity.

Imagine that your car is worth $30,000 and the balance on your loan is $35,000. If your car is totaled, the insurance company will pay you $30,000, but you owe $35,000. After applying the $30,000 insurance payment to the loan, you still owe $5,000, and you have no car.

  • Depreciation. Cars lose value fast. Auto specialist Edmunds estimates that a car loses 9% of its value when you drive it off the lot and 19% in the first year. That rapid depreciation can quickly put you underwater.
  • Low or no down payments. Some auto lenders give you the option to buy a car with a minimal or no down payment. That means you start with no equity in the vehicle. Combine that with fast depreciation and you could wind up underwater quickly.
  • High interest rates. If you agree to a high interest rate on an auto loan, a large portion of your early payments will go toward interest. That means you’ll pay the principal down slowly at first, making it hard to build equity in the car.
  • Long-term loans. The terms of car loans are going up fast and now average 70 months. A longer-term loan makes your monthly payment lower, which makes a car seem more affordable, but you build up equity more slowly and have a higher chance of being upside down. Learn more about the risks of long-term auto loans.
  • Purchasing a luxury car. Luxury vehicles are expensive and tend to lose value quickly compared to more typical cars. Even with a reasonable down payment, you could wind up underwater on your debt relatively quickly.

More than one of these may apply. If you purchase a luxury car on a long-term loan with no down payment and a high interest rate, you’re likely to be upside down on the loan for much of the loan’s term.

How to Know if You’re Upside Down on a Car Loan?

To figure out if you’re upside down on your car loan, follow these steps:

  1. Find your loan balance. You can check your most recent statement to see what the balance of your loan is. If you want to be thorough, you can ask your lender for a payoff quote, which is the exact amount you have to pay today to satisfy the debt, including interest that accrued since your most recent payment.
  2. Determine your car’s value. This can be more difficult because car values can be subjective. Consider checking sources like Kelley Blue Book or getting trade-in quotes from local dealers to get an idea of how much you can get for your car.
  3. Subtract your loan balance from your car’s value. If your car is worth more than the balance of your auto loan, you have positive equity. If the debt is larger than the car’s value, you’re upside down.

It’s also important to know how far upside down you are. If the difference between your loan balance and your car’s value is small, the impact will not be that great. If it’s large, you may have a bigger problem.

How to Avoid Going Upside Down on a Car Loan?

While going upside down on a car loan isn’t as bad as being upside down on a mortgage, it still isn’t something you want to happen. Here are a few tips you can use to avoid placing yourself in that situation.

  1. Make a larger down payment. The larger your down payment, the more equity you’ll have in the car right off the bat. That allows the car to depreciate by a greater amount without you going upside down on the loan.
  2. Don’t finance taxes and fees. Many auto lenders will let you roll fees and taxes into your loan balance. This will add to your debt. If you don’t make a down payment, you’ll be upside down right away, even before the car depreciates.
  3. Choose the right term. The longer the term of a loan, the less you have to pay each month and the more interest will accrue over time. Longer loans also leave more time for the car to depreciate, making it easier to wind up upside down.
  4. Choose a car with good resale value. Different cars depreciate at different rates. If you choose a car known to retain its resale value, then it will tend to depreciate more slowly. Slower depreciation can help you avoid going upside down on the loan.

Depreciation slows as a car gets older, so buying a used car can also help you beat the upside-down trap.

You’re Upside Down on Your Loan, Now What?

Going upside down on a car loan isn’t the worst thing in the world, but it isn’t something you should try to do. There are real implications.

  • Gap insurance. Most car insurance will only pay the value of the vehicle if it is stolen or destroyed. If you’re upside down, that’s not enough. You’ll need additional “gap insurance”, which will add to your insurance cost.
  • Resale or trade-in issues. If you want to sell your car or trade it in, you’ll have to add money to the deal to get enough to pay your lender.

If you find yourself upside and think you might want to sell your car or trade it in someday, you’ll want to try to get out from underwater first.

There are a few strategies you can use to get out from being upside down on a loan, such as making extra payments, refinancing to a shorter term, or even paying the debt in full. Which works best for you will depend on your personal circumstances and financial goals.

The post What Does it Mean to be Upside Down on a Car Loan? appeared first on FinMasters.

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