What Does It Mean To Have An Upside Down Car Loan?
Miranda Crace6-minute read
PUBLISHED: February 14, 2023
No matter if you just bought your first car or you’ve owned a vehicle for years, being “upside down” on an auto loan can increase the costs of car ownership. But how bad is it to have negative equity on a car loan, and how can you get out of this situation?
Let’s take a closer look at what an upside car loan means, how this can happen and strategies for getting rid of negative equity.
What Is An Upside Down Car Loan?
Being “upside down” – sometimes called “underwater” – on an auto loan means you owe more on your car than what it’s worth. For instance, let’s say you bought a truck a few years ago and have a remaining loan balance of $15,000 but the vehicle would only be valued at $13,000 if you listed it on the market today. In this scenario, you’d have $2,000 in negative equity on your car loan.
An underwater car loan can be especially challenging if you’re interested in purchasing a new vehicle or selling your current one outright. That’s because, if you tried to sell your truck or trade it in at a dealership, you would lose money on the transaction. Instead of having cash to put toward a new car or into your bank account, you’d pay $2,000 to sell or trade in your vehicle.
How Do You Get Negative Equity On A Car Loan?
Now that you know what it means to be upside down on an auto loan and how it can be problematic, you might wonder how this happens in the first place. Well, you can have negative equity on a car loan for a few reasons.
Here are the most common ways to end up underwater on a vehicle:
- Your vehicle lost value too quickly. New cars lose value once you leave the dealership, and they continue to depreciate with time. Sometimes, depreciation can even happen faster if demand for your car’s make and model rapidly decreases.
- Your down payment was too small. Some cash-strapped borrowers may forgo a down payment. If you choose this option, you’ll have negative equity right away since you’ll owe more than what the car is worth once you drive it off the lot. The same may also be true if you make only a minimum down payment.
- Your interest rate is too high. A high interest rate means less of your monthly payment will go toward your principal loan balance. In other words, it will take longer to pay off your car loan and limit your ability to create positive equity.
- Your repayment term is too long. Rising car prices have persuaded more people to choose 72-month auto loans over a shorter term. However, a long-term loan makes it more likely that your car will depreciate faster than you can pay for it.
- Your previous auto loan was underwater. If you trade in a car with negative equity, your loss could be rolled over into your new purchase if you buy a car from the same dealer where you bought your other car and traded it in. This could instantly give you an upside down car loan on your new vehicle. It’s best to avoid this practice, if possible.
- You bought a lot of extras. Maybe you decided to purchase accessories for your new vehicle. Although these extras can help you customize your ride, they’ll increase your loan amount and may not raise your car’s value.
How To Get Out Of An Upside Down Car Loan: 4 Options To Consider
If you’re upside down on your car loan, you’re not out of options. A few strategies are available for you to fix your finances. Up next, we’ll discuss each option in detail so you can determine which one will work best for you.
1. Refinance Your Auto Loan
Just like a mortgage, you can refinance your car loan to get a shorter repayment period or a lower interest rate, both of which can help you eliminate negative equity. A refinance is a great option for borrowers who’ve improved their credit score since applying for their current car loan.
Keep in mind: Refinancing an auto loan comes with benefits and drawbacks, so make sure to calculate your costs versus savings to confirm whether this option is right for you.
With a lower interest rate or a shorter loan term, more of your monthly payment will go toward your loan’s principal. Translation: You’ll spend less of your money on interest and more of it building positive equity in your car. You can also opt to use an unsecured personal loan to pay off your auto loan, meaning you could avoid a down payment or using the vehicle as collateral, which would both likely be required with a refi.
Unfortunately, using a refinance also comes with some disadvantages. If you decide to get a shorter loan term, your monthly payments will likely increase because you’ll have less time to pay back what you borrowed. And since you have to apply for and secure a new loan to replace your current one, you’ll end up paying more lender fees.
2. Make Larger Payments
If you can’t qualify for a refinance but still want to pay off your car loan early, you can choose to make larger monthly payments. This method is especially beneficial to borrowers with a tight budget, because you can slowly increase the amount you pay each month.
First, add an extra $15 to your monthly payment. If this doesn’t affect your budget, try adding a little each month until you’re satisfied with your larger payment amount.
While making small increases to your car payment might feel insignificant at first, you’ll soon see the effects on your loan’s remaining balance. And since you can control how much extra you put toward your payment, you can increase or decrease the extra amount as needed. You can also opt to make an extra payment whenever you have the means to do so.
Some borrowers may struggle with sticking to this goal. For instance, if you experience financial hardship or spend too much money on another expense, it’s easy to lose focus and return to paying the minimum monthly dollar amount.
3. Sell Your Car
The simplest way to get rid of an underwater auto loan is to sell the vehicle that has negative equity. However, this doesn’t mean you should sell your car without doing some research. Start by figuring out the value of your car, which you can do through websites like Kelley Blue Book.
Next, decide how you want to sell your car. You can sell it yourself, work with a dealer or find a third-party buyer service. If you want to sell your vehicle to a dealership or service, you probably won’t get top dollar for it. That means you might have more luck with a private buyer.
If you sell your car for a high enough price, you can pay off your upside down loan. Even if you end up selling it for less than the amount owed on the loan, you won’t accumulate more negative equity as the car ages since you’ll no longer own it.
Selling a used car can be time-consuming and labor-intensive. You have to do your research, calculate the vehicle’s value, list it online and negotiate with potential buyers. Of course, this effort could be worth it to remove an upside down auto loan.
4. Trade Your Car In
Although your local car dealership won’t give you the market price for your trade-in, they still might work with you to help offset your current loan’s negative equity. Some dealerships offer their own financing or partner with a bank or credit union, so they can possibly help a buyer pay off their existing loan or secure a competitive interest rate on a new car.
Just make sure you know your car’s trade-in value and how much negative equity you have on your auto loan before working with a dealership. This will make negotiating with your salesperson easier.
Similar to selling your car, trading in the vehicle means you no longer have to worry about getting more negative equity. And like refinancing, you could get a lower interest rate on your new auto loan.
If the dealership you work with pays off your previous upside down car loan, that cost will likely be rolled into your new loan and you’ll be paying double interest on the debt, which is why we don’t recommend this strategy. Instead, consider making a larger down payment or picking a cheaper vehicle to avoid another underwater car loan.
Final Thoughts: Being Upside Down On A Car Loan Can Hurt Your Finances
Buying a car can be super-exciting since you get to test drive different models, compare features and consider adding accessories. However, dealing with an upside down car loan can be challenging. Thankfully, you have access to a variety of options that can help you pay off negative equity.
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