What is an upside-down car loan?
An upside-down car loan can really catch you off balance, and it’s a growing problem in the United States, according to Debt.org, America’s debt help organization.
You may have heard the phrase before and are wondering what exactly an upside-down car loan is. It’s a situation in which the money you owe the auto lender is more than the vehicle is actually worth.
For example, you still owe the lender $12,000 on your car, but its value is just $9,000, so you are upside down on that loan by $3,000.
An upside-down car loan is also known as being “underwater,” and is often referred to as negative equity.
How an upside-down car loan might occur
There are numerous ways negative equity on a vehicle may arise. Common scenarios include:
- Depreciation – Cars inevitably lose value once they’ve been purchased, and new cars depreciate by about 20 percent as soon as they are driven off the dealer’s lot. By year three, they are reckoned to have lost 50 percent of their value. That’s a large chunk, and this may be a factor in an upside-down car loan, when, over just a few years, the money owed on the auto loan becomes greater than the vehicle’s market price.
- Small or no down payments – Seeing as new cars depreciate quickly, and could lose a fifth of their value on exiting the dealer’s driveway, putting little or no money down to reduce the loan amount at the start may be a factor that contributes to the development of an underwater loan. And that sinking feeling.
- Long loan terms – A lengthy loan term might mean car payments are being made at a slower rate than the depreciation of the vehicle’s value.
- Rollover loans – A rollover loan may take place when you’re buying a new car but you still owe money on your current vehicle. The debt on the existing loan is added, or rolled over, into the loan for the new car. This will increase the total loan amount and may result in negative equity if the loan value is greater than the value of the new car you’re buying.
- Overpaying for a car – Paying above the market price for a vehicle might inflate the loan amount needed to buy the car, and is another possible factor in an upside-down auto loan.
Knowing your options
If you find yourself upside down and are looking to change your vehicle, what are the options? The Federal Trade Commission (FTC), a consumer protection agency, offers some straightforward advice to help with the main choices.
Buying a car
First of all, check the value of the your current vehicle to see exactly where you stand financially, says the FTC, and consider waiting to buy a car until you’ve paid back enough of your auto loan to the point where you have positive equity, and owe less than your vehicle’s value.
This process could be speeded up by making extra payments that go completely toward paying down the principal loan amount, rather than to interest charges, it says. You can read more about the roles of auto loan interest and principal in our article about how car loans work.
Selling your car
Selling your car yourself is an option, and may get you a higher price than trading it in to a dealership.
If you do decide to trade in your vehicle, which is a common choice, there are a number of things to be aware of that may help.
A dealer might promise to pay off your current loan upon trading in, but when you have negative equity, it may not be entirely paid off, points out the FTC. “Make sure you understand how your negative equity is being treated before you sign a contract,” it says, and find out if it is being rolled into the new loan, and what the terms will be, including the monthly payment. The length of the loan is also important as a longer loan term means it may take more time to reach positive equity, and turn from upside down to right side up.
If you’re ready to buy your next car, apply for auto financing online with RoadLoans to get an instant decision.