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Key Points:
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Being proactive in managing your car loan can prevent and resolve negative equity.
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Always consider the total cost of ownership, including depreciation, when purchasing a vehicle.
An upside-down car loan is a situation where you owe more money on your car loan than the car is actually worth. This is also known as being "underwater" or having "negative equity" in the car. It often happens when a car depreciates in value faster than the loan balance decreases.
How Upside-Down Car Loans Can Occur:
- Depreciation: Cars lose value quickly, especially new ones. In the first few years, a car's value can drop significantly.
- Low Down Payment or No Down Payment: If you start with a small or no down payment, you're financing almost the entire cost of the car, which can quickly lead to an upside-down loan as the car depreciates.
- Long Loan Terms: Longer loan terms can mean smaller monthly payments, but they also mean slower repayment. The car's value might drop faster than you're paying off the loan.
- High-Interest Rates: If your loan has a high interest rate, more of your monthly payment goes towards interest rather than reducing the principal balance, slowing down the rate at which you build equity in the car.
For example:
Imagine you buy a car for $20,000 with a loan and no down payment. After a year, the car's value drops to $15,000, but you still owe $18,000 on the loan. This means you're upside-down on your loan because you owe $3,000 more than the car is worth.
Why It's Risky to be Upside Down on a Loan
- Limited Flexibility
You owe more than the asset's value, making selling or trading difficult without incurring additional debt. - Financial Burden
Rolling over negative equity into new loans can increase overall debt and prolong repayment periods. - Credit Risk
Related financial strains, like missed payments or refinancing, can negatively impact your credit score. - Insurance Gaps
Insurance may not cover the entire loan amount if the car is totaled or stolen, leaving you responsible for the difference. - Emotional Stress
The financial strain from being upside down can lead to significant stress and anxiety.
How to Get Out of an Upside-Down Car Loan
Different cases may inform buyers how to get out of an upside-down car loan.
Here are some common suggestions on how to go about it:
- Pay Off Your Loan Faster
If possible, make extra payments or pay a lump sum to reduce the loan amount quickly. This helps reduce the overall interest and get out of negative equity. - Refinance Your Loan
If you can't make extra payments, consider refinancing for better terms and lower interest rates. This won't eliminate negative equity but can make repayment easier. - Sell Your Car
You might be able to cover the loan balance and negative equity through a private sale. However, selling a car with negative equity can be complex, and you should consult with your lender. - Surrender Your Car
Voluntary surrender of the car to the lender is a last resort. It's preferable to repossession, as repossession can severely impact your credit score.
READ MORE: How to Buy a Used Car in 5 Steps >>
How to Avoid an Upside-Down Car Loan
- Offer a larger down payment (at least 20% of the car’s value).
- Choose a short repayment term, ideally not more than four years.
- Avoid unnecessary add-ons that can inflate the loan.
- Shop around for the best rates and terms.
- Consider buying a used car, which depreciates slower.
- Pay taxes and fees upfront to reduce the loan balance.
Conclusion
In an upside-down loan, the car buyer purchases a car on credit but ends up paying, or owing, more than the value of the car.
How to not be upside down on a car loan requires a proactive approach by a buyer. That includes:
- Conducting due diligence and research on the price of the car
- Ascertaining that the terms of the agreement correspond to what was agreed on, especially regarding pricing.
- Putting down a substantial down payment on the car and committing to shorter loan repayment terms.
Of course, it would be wise for a car purchaser to ensure they can afford the car's full value instead of relying on debt to finance in the long run. Sometimes, it’s better to live within your means financially so as to avoid getting yourself into trouble.
Will a Bank Refinance an Upside-Down Car Loan?
Possibility: It is possible, but not guaranteed. Banks and financial institutions have varying policies regarding the refinancing of upside-down car loans.
Can You Trade in an Upside-Down Car Loan?
Dealerships may allow you to trade in a car with negative equity, but the outstanding balance is often rolled over into the new loan.
Does Negative Equity Hurt Your Credit?
Negative equity, by itself, does not impact your credit score. Credit reports do not reflect the equity status of your loan.
Can you roll over negative equity into a new car?
Rolling over negative equity should be carefully considered as it can lead to increased financial burden and a cycle of debt.
Can I trade in a financed car for a cheaper one?
Trading in for a cheaper car can be a smart move to reduce monthly expenses, but be mindful of the total loan cost, especially if rolling over negative equity.
Article Topics
Auto Loans
Matthew is a freelance financial copywriter with 14+ years in financial services. He holds a Bachelor of Science degree in Economics with business and finance options and is a CFA Charterholder. He is from Vancouver, Canada, but writes from all over the world.
