Most people have heard about how quickly new cars depreciate, but many don’t know the potential consequences of an upside down car loan. When you’re upside down on your car loan, it means you owe more on the car than it’s worth. It’s also known as negative equity or being underwater, and it happens more often than you’d think. In most cases, an upside-down car loan should be temporary. However, there are certain situations that can make being underwater risky.
This guide explains what an upside-down car loan is, why it’s risky, and how to get out of an upside-down car loan.
What is an Upside Down Car Loan?
When the balance of your loan is greater than the value of your car, you have an upside-down car loan. New vehicles are expensive. Unfortunately, they don’t retain their value once you begin driving them. Vehicles depreciate most during their first year of ownership, often leaving new car owners with an upside-down loan. While your car will continue to depreciate, your monthly payments will lower your balance until you are no longer underwater. Still, if you don’t know the details of an upside-down car loan, it could leave you in financial distress.
How You End Up with an Upside Down Loan
We’ve mentioned that depreciation is the main cause of upside down car loans. However, there are certain circumstances that make you more likely to have an upside-down loan.
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- Low or no down payment loans: A down payment will help you counteract the effects of depreciation. Without a down payment, you’re likely to be underwater during the first few months of car ownership.
- Long-term loans: A long-term loan means you’ll have lower monthly payments, but it means your balance will be higher for a longer period of time. As a result, the length of time you hold an upside-down loan will be longer as well.
- Fancy options: Add-ons seem like a great way for you to get the most out of a new vehicle. However, they don’t really increase your car’s value. As such, you’ll have a higher loan for a car that retains the same value.
- High-interest loans: High-interest rates slow down the amount of time it takes to pay down your loan, as a large portion of your payment is spent on interest.
- Cars that depreciate quickly: Some expensive vehicles depreciate in value more quickly than others. Conducting research before making a purchase can help you avoid an upside-down loan.
Why is it Risky?
An upside-down car loan isn’t automatically a problem. It’s common during the first months of paying down a loan if you made a small down payment. However, if your situation changes, your upside-down car loan could put you in a position to take on even more debt. Being on an upside-down loan can be risky in these situations.
- Your car gets totaled in an accident. In the event of an accident, your insurer pays out the current value of your car. When you’re underwater, the payment won’t be enough to pay off your vehicle.
- You default on the loan. If you can’t make your payments, your best option is to downsize to a cheaper vehicle. However, to use the car as a trade-in, you’ll want to pay off the negative equity first.
- Your life situation changes. When you signed the contract to pay off your new car, you planned to keep it for the duration of the loan. However, if you suddenly need more room, lower gas mileage, or an all-wheel drive, you might find yourself in the market for a new vehicle. You’ll have to pay off the negative equity or roll it over into your new loan.
How to Find Out if Your Car Loan is Upside Down
Is it possible to have an upside-down car loan without knowing it? Absolutely. In fact, an upside-down loan is common, and if you owe money on your car, you could be underwater. Luckily, it’s easy to figure out where you stand.
Begin by finding out exactly how much you owe. Contact your lender and request a payoff quote. This will tell you exactly how much you owe, including interest. Once you know your balance amount, it’s time to figure out how much your car is worth. Kelley Blue Book’s car value calculator is a good place to start. You can also get quotes from local auto dealers and search local sales to see how much similar vehicles bring in third-party car sales. Once you have both values, subtract the remaining loan balance from your car’s value to determine your equity. If the number is negative, you’re upside down on your car loan.
How Can You Get Back on Track?
Once you know that your car loan is upside down, you can take steps to get back on track or avoid potential risks while you pay down your loan. While it’s common to be underwater on a loan, it’s not an ideal situation. These steps can help you avoid the risks that can arise with an upside-down car loan.
- Get gap insurance. Unless you’re in a position to immediately pay off the negative equity on your car, risk reduction should be your first priority. While collision is designed to pay for the current value of your vehicle, gap insurance is designed to pay for the gap you experience when your loan is upside down.
- Pay down your loan faster. If you can afford to pay a little more each month, you can decrease the amount of time your loan is underwater. Anything extra you pay will go directly toward the principal instead of paying off interest.
- Consider refinancing the loan. If your credit wasn’t in great shape when you got your loan, you are likely in a position to get better conditions. With a lower interest rate, you can pay down the loan faster without making higher payments.
An upside-down car loan isn’t the end of the world, but it can lead to financial distress. However, if you don’t know where you stand, you can’t take steps to reward risks. Learn more about how gap insurance can help you reduce your risk when you have an upside-down car loan. Contact an independent insurance agent at LoPriore today.
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