Being in an upside down loan is less than ideal. It’s something no one ever anticipates, but it can happen to the best of us for a number of reasons. An upside down loan (also called an underwater loan) is when you owe more on your car than your car is worth. But just because you are underwater, all is not lost. There are a few steps you can take to swim to shore and get out of your situation.
Here’s everything you need to know about upside down loans (and how you can get out of one).
How do you get upside down on a loan?
First up: how do you even get an upside down loan? When it comes to buying a car, it’s actually pretty easy to end up underwater.
You financed with no money down.
Dealerships are constantly running “deals” that feature financing with no money down. This is never a good idea. Cars depreciate quicker than almost every other asset, losing about 20% of their value in the first year alone. New cars lose 10% of their value simply by leaving the lot. So if you put no money down, you are immediately going to be in an upside down loan.
Let’s look at an example. You decide to finance a $30,000 car with no down payment. This means that once you leave the lot, your car is only worth $27,000, and your loan is still for $30,000. Financing with no money down is the quickest way to get an upside down loan, and it will be hard to turn that around.
You picked a long repayment period.
Another easy way to end up in an upside down loan is to choose too long of a repayment period. The longer your repayment period is, the smaller your monthly payments will be. And this may seem great for your monthly bills, but this means that the depreciation on your car will outpace your monthly payments quickly and your loan will be upside down in no time.
You didn’t do enough research.
You can also get upside down in a loan by simply not doing enough research and paying too much for your car in the first place. If your car is really only worth $27,000 brand new and you paid $29,000 for it, there’s a good chance your loan will be upside down quickly.
You bought a luxury car.
Luxury cars tend to depreciate at a faster pace. Therefore if you are making minimum payments or have a longer repayment period, depreciation can very quickly get ahead of you.
You bought a car that was out of your budget.
Buying a car that is out of your budget in the first place can land you in an upside down loan. This means that you will have a hard time keeping up with your monthly payments, and you may end up upside down.
You got a lot of unnecessary add on features.
Nothing ticks up a new car price faster than add ons. And a lot of the time they do not truly add value to the car.
You got a high interest loan.
The higher your car loan APR is, the more money that is going to the bank and not to paying down the balance. Depreciation will quickly outpace low repayment with high interest loans.
How do I know if I am in an upside down loan? Is being upside down on a loan bad?
If you are wondering if you have an upside down loan, it’s pretty easy to figure out. Start by calling your lender and asking them for a payoff amount. This will include all of your remaining payments as well as any additional fees. Then compare this number to the market value of your car (you can check Edmunds or Kelley Blue Book to see what market value is). Then simply compare the two numbers. If the payoff amount is higher than the market value, you are in an upside down loan. If your payoff amount is lower than the market value, you are ok (but make a note of how close these numbers are to make sure you aren’t toeing the edge of an upside down loan).
While it doesn’t sound good to owe more on your car than it is worth, is it really that bad? Not necessarily, but it does put you at a higher risk financially. Things happen unexpectedly, and if you need to get rid of your car, you will be in a less than ideal situation.
Your car gets totaled.
If your car is totaled your insurance will only pay out what the current value of your car is. So if you owe $20,000 on your car and insurance only pays you $15,000, you are left on the hook for $5,000.
You need a different car.
If for some reason you need to get rid of your car and get a new one, you will not really be able to get more than market value for your car (but you will still owe the bank on the total amount of the loan).
You are unable to keep up on payments.
If you are unable to keep up on your monthly payments (probably because the car was out of your budget in the first place), then you will need to sell your car to get a different one. But again, you will only be able to get the market value of your car and will need to continue making payments to your lender.
What can I do with an upside down loan?
Drive through the loan
If you don’t plan on needing a new car soon and you are able to comfortably make your monthly payments, you don’t necessarily need to do anything. You can simply drive through the loan, making consistent monthly payments and driving as normal. You will eventually pay off your car and it won’t be an issue.
Make extra payments
If you are able to make extra payments every now and then, that will greatly help you catch up to your car’s true value. Extra payments will usually go towards the principal (not the interest) and can make a real difference.
Refinance to a shorter repayment period
If you are able to refinance your car loan to a shorter repayment period this can also help get you out of an upside down loan. This will help close the gap between depreciation and your loan’s value. Many lenders do not refinance loans that are upside down, but if you have good credit you may be able to secure a different loan.
Get GAP insurance
GAP insurance (Guaranteed Asset Protection) is designed to cover the difference between what the car is actually worth and the amount that you owe on the car. In other words, if you total your car and owe $2,000 more than what your insurance will pay out, your GAP insurance will pay that difference. It’s another added cost but it might be worth it in the event of an emergency.
What can I do to prevent an upside down loan?
It’s best to avoid getting an upside down loan in the first place if you can help it. Here are some ways to keep your loan amount in check.
Make a down payment.
Down payments are always a good idea when it comes to buying a car. A down payment is arguably the best thing you can do to ensure depreciation doesn’t put you upside down immediately. Experts recommend a 20% down payment to put you in the best position.
Pay your taxes and fees upfront.
Many dealers will allow you to roll your taxes and fees into your car payments so that you can pay nothing (or next to nothing) upfront. Avoid doing this as it will just add more to your loan.
Do your research.
You should always do your research when making a large purchase like a car. You want to be sure of the following:
- You aren’t overpaying on the actual market value of the car
- The car you are buying has a slow depreciation rate
- The car payments will fit into your monthly budget (transportation costs should be less than 20% of your monthly budget–car payments, gas, parking, and insurance)
Pick a repayment period that isn’t too long.
A long repayment period means smaller payments. If the only way you can afford a car is to pay it off over six years, then you can’t afford the car.
That’s everything you need to know about upside down car loans.
While it’s best to avoid an upside down loan altogether, sometimes we end up in less than ideal situations. If you are unable to make extra payments on your loan, consider getting GAP insurance to help prepare against an emergency.
If you’re not underwater but having trouble making payments, consider refinancing your car loan with Auto Approve. We can help save you money, time, and frustration! So don’t wait, contact Auto Approve today to get your free quote!
