What is an Upside Down Car Loan?

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An upside-down car loan arises when a car buyer purchases a car on credit but ends up paying (or owing) more for the car than it’s worth. Like a bad marriage, upside-down car loans have the potential of wrecking a person’s finances, leaving them wallowing in a seemingly bottomless pit of stress and anxiety.

Upside-down car loans are also colloquially known as underwater car loans. Below, we discuss the people likely to be affected by such loans and the resulting problems they may face. We also look at the tell-tale signs of a potential upside-down car loan and outline some of the common solutions available to buyers who find themselves with such loans.

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What Does it Mean to be Upside Down on a Car Loan?

So, what does it mean to be upside down on a car loan? Well, it means that the buyer’s car debt exceeds the value of the car. For instance, a buyer may purchase a car at $50,000 on loan, but in the course of repaying the loan, the car depreciates in value and is worth, say, $20,000. Such a buyer is said to have an upside-down or underwater car loan on their hands.

That is because, even though the vehicle’s actual value has dropped to $20,000, the buyer is still obligated to pay the entire loan amount. In other words, the lender is entitled to the entire sum, including the ‘extra’ $30,000 that is over and above the car’s actual value. In this case, that $30,000 is known as negative equity for the buyer.

A car buyer who suffers an underwater car loan ultimately loses money as they end up paying an exorbitant price for the vehicle.

Why it’s Risky to be Upside Down on a Loan

The most obvious detriment of an underwater loan is the financial loss that comes with paying more for the car than its actual value. In addition, the buyer could be exposed to the following risks:

  • Bad Credit Score

In case the borrower loses their source of income and is unable to keep up with the loan payments, they might be forced to sell the car to a third party. However, since the vehicle can only fetch its actual cost, the borrower still has to settle the negative equity with the lender, failure to which they risk having a bad credit score or a civil suit filed against them.

  • Loss in case the car is totaled

Similarly, should the vehicle be involved in an accident and get written off, depending on the type of cover the borrower has, their insurance may compensate them. However, even under the most comprehensive cover, the insurer shall (at most) only pay out the actual cost of the vehicle. That still leaves the buyer liable to the lender for the negative equity.

  • Difficulty trading in or purchasing a different car

The same risk of loss of money arises when the buyer wishes to change vehicles. They cannot simply trade in the car for another and call it even. They still have to contend with paying the negative equity to the lender, as the car can only fetch its actual value/ worth.

How to Get Out of an Upside Down Car Loan

Different circumstances may inform buyers on how to get out of an upside-down car loan. Here are some common suggestions on how to go about it.

  • Large down payment

With approximately 20-25% of cars losing their value to depreciation in the first year alone, slipping into an underwater car loan might happen sooner than most buyers imagine. To forestall the incidence of upside-down car loans, a buyer may consider putting down a hefty down payment on the loan upfront. Down payments not only reduce the outstanding sum but also significantly reduce the taxes payable by the buyer while staving off negative equity.

  • Avoid cars with unnecessary add-ons

Typically, cars endowed with extra gadgets and luxury features attract a higher price compared to their basic counterparts. By extension, a higher price leaves the buyer shackled to more payments. For purchasers procuring the car under a loan, it is worth considering doing away with the expensive trimming and opting for a base model of the car instead.

  • Short term loans

At the financing stage, another common tactic employed by shrewd buyers is opting for loans with short-term repayment periods. While that also means higher installments, it is likely to afford the buyer a greater chance of clearing the loan before the loan turns upside down. Conducting prior research and doing a comparative analysis may enable the buyer to know which vehicles are within reach on a short-term loan basis.

  • Refinancing

A buyer may refinance an upside-down auto loan by talking to their lender and renegotiating the loan repayment terms. Getting a personal loan for refinancing is also relatively easy. With a refinancing, the buyer can increase their monthly payments for the car, which means less interest payable on the outstanding sum.

  • Car swap

The buyer may also turn an upside-down car loan into an upside-up one by opting to swap the car for a new one that comes with a rebate or discount. However, the availability of this option is highly dependent on the buyer’s car dealership and what they are willing to offer. Some of the dealers might, for instance, have a sale on particular types of vehicles or a reward scheme for their loyal clients. Underwater car loan buyers could take advantage of such offers to swap their cars for more affordable ones

  • Channel negative equity to a lease

Another common option for buyers who already have an underwater loan is to trade in the car in favor of a rental and have the outstanding purchase price, and negative equity rolled over into the lease. This option tends to favor buyers with an unwavering ability to effect payments. Compared to the purchase arrangement, leases come with lesser interest. Also, under a lease, the customer is not subjected to long-term depreciation costs.

READ MORE: How to Buy a Used Car in 5 Steps >>

How Does a Loan Turn Upside Down to Begin With?

An otherwise sound car loan can turn upside down pretty quickly. Several factors may contribute to this. Here are the most common ways car buyers find themselves with an underwater loan

1. Failure to do their homework

Some car buyers neglect or fail to conduct prior research on the vehicle they are keen on buying as well as its pricing. Consequently, they may end up agreeing to buy the car at a price point that is way above the prevailing market rates. When this happens, such buyers immediately find themselves with an underwater loan upon signing the deal.

2. Low or little down payment

All cars depreciate in value the moment they leave the showroom. To hedge against depreciation, it is common for wise car buyers to put down a substantial down payment on the car. Failure to do so may increase the amount of money owed (including the tax payable) as the car continues to lose value.

3. Unduly long loan terms

Contrary to what some buyers may think, loans with extended payment periods are not cheaper. That is because the longer the repayment term, the higher the interest charged. The buyer, in such a case ends up paying far more than the vehicle’s worth. A similar situation might also arise where a buyer goes for unnecessarily low installments which prove more expensive in the end.

How to know if your Car Loan is Upside Down

A potentially underwater loan may have one or several warning signs. Prospective buyers may look for the following elements when considering whether or not to take a particular car loan:

1. Variation in car price

Where a dealer unilaterally varies the price of the vehicle to an amount not previously agreed on, the buyer may consider that as a red flag to a potentially underwater loan. The price verbally communicated by the salesperson ought to be consistent with that reflected in the written agreement.

2. Wild penalties

If the repayment penalties seem to be unreasonable, they probably are and may quickly turn a loan upside down. A common method of ascertaining whether the penalties are reasonable is by running a comparison between the rates offered by different dealerships.

3. Inclusion of unnecessary add-ons

Wise buyers tend to be wary of what is included in the car purchase. That includes the question of whether the car shall have any fancy gadgets and whether the price is inclusive of the same. When fancy add-ons pop up in the written contract and increase the price of the vehicle to an amount higher that what the buyer had planned for, there is a higher likelihood of it turning into an underwater car loan.

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.

Matthew Levy Matthew Levy Last update:
Matthew is a freelance financial copywriter with 10+ 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.