Ok, let’s get one thing straight – if you have an underwater car loan, it doesn't actually mean that your car is under water. But, in many ways, it can feel just as helpless. And, while being in an underwater loan is less than desirable, it is probably more common than you think.
But fear not! Today we are diving (pun intended) into the world of underwater loans. We’ll look at how you can get out of a negative equity situation – or even avoid the situation in the first place!
Here are our top tips on avoiding underwater loans and how to get out of an underwater loan if you have one.
Everything you need to know about underwater loans
What does being underwater on a loan mean? How does a loan become underwater?
Whenever you take out a loan, whether it’s on a house or on a car, you run the risk of your loan becoming underwater. Being “underwater” simply means that you owe more than your asset is worth.
While we all like to think that we are expert researchers who make thorough decisions, that is sometimes not the case. Buying a car is exciting, and it is way too easy to get swept up in the excitement of car shopping and end up in a bad deal. The bottom line is there are many reasons a loan can become underwater.
You put zero money down
This is one of the quickest ways to end up in an underwater loan. Cars lose about 10% of their value the minute you drive them off of the lot. By the end of the first year, your car will be worth about 20% less than when you bought it. So let’s do the math on that.
You took out a loan for $25,000 for the cost of the car with zero money down. This means that second you drive the car off the lot, your car is worth $22,500. But your loan is still for the entire $25,000. Just like that, your loan is underwater.
You paid too much in the first place
If you didn’t do your research, you may have paid too much for the car from the get go. If your car was actually valued at $28,000 but you took out a loan for $30,000, you were underwater in your loan from the beginning.
You took out a long term loan
The longer your loan repayment is, the more likely you are to end up underwater. If you are using an 84 or 96 month repayment, your monthly payments likely cannot keep up with the depreciation.
Your car was out of your budget
If you took out a loan with the lowest monthly car loan payments possible because you just HAD to have that particular car, it’s easy to end up underwater. Whether your payments are too low to keep up with depreciation or you miss payments here and there when you can’t make ends meet, the result will be ending up in an underwater loan.
This can also happen by saying yes to all of those add ons from the dealership. The upgraded sound system, the fancy integrated computer system, the all-weather mats; these all add up and add on to your monthly payments.
You had a rollover loan
If you owed money on your last car, the dealer may have rolled that remaining amount into your new loan. In this case, you are essentially paying for two loans at once. This can easily make your loan amount much higher than the value of your new car.
You had a high interest loan
If your credit score and credit history were not great, you may have only been eligible for a loan with a higher interest rate. The higher rate makes it much more difficult for your payments to keep up with depreciation.
What steps should you take to avoid getting into an underwater loan?
As the saying goes, an ounce of prevention is worth a pound of cure. So what steps should you take to avoid getting into an underwater loan in the first place?
Purchase GAP insurance
Guaranteed Asset Protection (GAP) insurance is one of the best ways to prevent a loan from becoming underwater. GAP insurance is designed to cover the difference between what your car is worth and what you owe. GAP will protect you from depreciation (as well as cover you when collision and comprehensive coverage do not).
Put money down up front
Experts recommend always putting a down payment on your car. Putting 20% down will give you a good head start on the depreciation that will immediately start accumulating.
Do your research – thoroughly
Make sure you know what the car you want is worth before you even step foot in the dealership. Use websites like Kelley Blue Book and Edmunds to get an accurate idea of what you should be paying for your new ride.
Think about a realistic repayment period
The longer your repayment period is, the more money you will end up paying in the long run. After all, you are paying interest on that entire period. On top of that, the older your car is, the faster depreciation will creep up on you. Keeping a shorter repayment period will ensure that you save money in interest AND stay ahead of depreciation.
Pick a car within your means
Car shopping can be so exciting and it’s easy to ignore the budget that you know deep down you should follow. But you need to make sure that the car you pick has payments that are manageable. Sit down with your budget and determine what you can comfortably afford, keeping in mind that unforeseen emergencies pop up and you never want to end up stretched too thin financially.
Keep this in mind when you are picking out your addons and upgrades as well – some of those additional items can easily add thousands on to your total loan.
Make sure you have a good credit score before you finance
Your credit score is the main contributor to the interest rate you will be offered. The higher your credit score is, the lower your interest rate will be. Get a copy of your credit report beforehand and look for any areas of concern. Was anything misreported? If there is an issue, report it immediately to the credit bureau.
How do you get out of an underwater car loan?
But what if it’s too late and your car loan is already underwater? Don’t fret. As long as you are not in a rush to get rid of your car, there are a few steps you can take to chip away at the difference between what the car is worth and what you owe.
Continue making your payments
Keep making your scheduled regular payments. Once you own your car and it is your asset, you can decide what you would like to do, either sell it, keep it, or trade it in. But at that point you will have equity in the vehicle.
Make additional payments
If you are able to make extra payments on your loan, it will help bridge the gap between what you owe and what the car is worth. You can get ahead of the depreciation by being consistent with extra payments. You can even look into paying the loan off entirely if you have the capital to do so. But be sure to check your loan agreement to see if there is an extra fee if you pay off your loan early.
Refinance your loan
This may not be possible depending on your situation, but a car loan refinance might be worth a shot. Traditional banks typically do not refinance underwater loans, but a local bank or credit union might consider it. If you are able to refinance your car loan, you might be able to pay off the car faster.
Sell your car
If you are desperate to get rid of your car, you can always sell it privately. Selling your car privately will get you more money than if you were to go through a dealer. Do some research on Kelley Blue Book to find out what your car is worth, and try to honestly assess what condition it is in. Give your car a good detailing, fix any maintenance issues, and advertise locally as well as online. You might be able to sell your car and pay off most of the loan from that sale.
This has other drawbacks of course, the main issue being that you will no longer have a car. But this will depend greatly on your personal situation and how bad you want to be free of your car.
And that’s everything you need to know about underwater loans.
The best way to get out of an underwater loan is to never get into one. Be sure to do your research and purchase GAP insurance when you take out your initial loan.
At Auto Approve, we know how important GAP insurance is, which is why we make sure your new loan comes with it when you refinance.
If your loan isn’t underwater but you are having trouble keeping up with payments, it might be time to refinance with Auto Approve. We work with lenders to find you the lowest interest rates around and can change your repayment plan to make your payments more manageable.
So if you want to refinance a car loan, get your free quote today!
