When you owe more on your car loan than it is worth, this situation is known as being upside down. In other words, your equity is negative.
Since autos lose 20% of their value as soon as they are driven off the lot, upside-down loans are practically a given. By the time you reach the first traffic light, a car that cost $25,000 is only worth $20,000 when you drive it off the dealer’s lot. You can already owe more than the car is worth depending on how much money you put down.
In 2022, the average cost of a new car was $45,927, while the typical loan was $39,340. This means that if you want to avoid leaving the dealership with negative equity, you must put down a minimum of $7,800 on a new car of average price.
It’s unlikely that you will receive enough money from the sale of a car with negative equity to pay off your debt. You will still be responsible for the remaining sum if you total your car in an accident because insurance only covers its value, regardless of how much you owe. This makes it more challenging to get a replacement automobile.
How to Become Inverse on a Car Loan
A new car is thrilling, let’s face it. Unfortunately, excitement and sound financial judgment are not always compatible. There are numerous ways that excitement might lead to an upside-down auto loan.
Inadequate research: Insufficient research is done by many consumers regarding the costs of comparable models. You are already in the red if you purchase a car with a $30,000 sticker price while comparable models are going for $27,500.
Loans with no money down: Since cars lose 50% of their value by the third year and 20% of their value immediately, the less money you put down, the more upside down you will be.
Long-term loans: You can manage your monthly payments with terms of 72 or even 84 months, but you still have to pay for a car that is at least five years old. Depreciation cannot be kept up with by payments for that long.
Loan rollovers: The dealer will frequently propose to roll the negative equity on your previous vehicle into your present loan. This indicates that you are paying more than the new car is actually worth.
Unnecessary options: Avoid being persuaded to purchase unnecessary accessories, such as a sunroof, leather seats, heated steering wheels, equipment that connects to a smart phone, etc. Options increase debt and can never be made up for when you sell the automobile.
Expensive automobile: Purchasing a car will compete with other important payments, such as housing, food, student loans, and more, pushing you beyond what you can afford.
High-interest loans: Arrange your finance in advance and resist pressure to use dealer financing, which typically has a higher interest rate.
How to Get Out of a Bad Auto Loan
What should you do if you are in default on your auto loan?
It’s good to know that there are ways to get out of a car loan unless you’ve totaled the automobile in an accident or need to sell it right away.
Identify Negative Equity
Finding out how far underwater your car loan is is the first step. The calculation of negative equity is as simple as subtracting your debt from the value of the car.
Enter information about your car, like as its model, year, condition, mileage, and more, into the online calculators on Kelley Blue Book or Edmunds to determine how much it is worth. There are additional guides from the National Automobile Dealers Association. Due to the variability in computations, check multiple sources. Be truthful when describing the state of the car; there is no value to temporarily deceiving yourself that it is worth more than it actually is.
Check your loan account online to see your balance (the majority of lenders offer this feature). Because interest accruals change daily, call your lender and ask for the precise amount (or if you don’t have an online account).
If you borrow $17,000 while your car is worth $11,000, for example, you have negative equity of $6,000. Therefore, even if you sold the car for its market value of $11,000, you would still owe the lender $6,000 in interest.
Speak with your lender
After determining the negative equity, call your lender to go over your choices. This may make you uncomfortable. In fact, you might be avoiding your lender entirely if you’re behind on payments. Remember that the lender wants to avoid losing money on the loan, so they are just as eager to find a solution as you are.
Other options, like as refinancing, may be provided by some lenders. Even though others might not have any suggestions for you, it’s still a good idea to ask and let them know you’re considering your alternatives.
Maintain your payments
The top objective right now is to continue paying on-time payments, regardless of how you intend to exit your upside-down loan. As a result, the loan balance is reduced and equity is also increased. Your credit score is protected, which makes it simpler to get better loan arrangements the following time around. In event of an accident, gap insurance will pay the difference between an insurance payout and the loan balance if you have a lot of negative equity.
When speaking with your lender, you must make it obvious if you are unable to make car payments. Speaking with a nonprofit credit counselor could be helpful if the lender has no other options. The National Foundation for Credit Counseling has accredited nonprofit organizations that offer free consultations with credit counselors who will analyze your finances, assist with budgeting, and offer solutions to help you pay down debt.
Pay as much as you can in installments
Paying more each month toward the principal is another method to get out from under an upside-down auto loan, if you have the money to do so. This will accelerate equity growth and balance reduction. Check your loan agreement to check if there are any early payback penalties before you do.
Additionally, you can pay off your loan with savings. The drawback is that you will no longer have enough money to put down a deposit on your next vehicle, and few banks will give loans to borrowers without a down payment.
Changing a downside-down loan
You can also get out of a car loan that is in default by refinancing with a fresh loan. Refinancing enables you to pay off the car more quickly or at least gain equity if interest rates are lower than they were when you took up the initial loan. Large lenders frequently show no interest, but a local bank or credit union may.
If a home equity loan saves you money on interest, it can be an excellent choice if you own a property.
You could also be able to transfer the remaining amount on your auto loan to a credit card with an introductory APR of 0%. Refinance the remaining sum at a credit union or peer-to-peer lender at the conclusion of the introductory term, which for most cards lasts between 12 and 18 months.
Selling Your Turned Around Car
Selling the automobile and taking out a second loan to cover the negative equity is a possibility if you are hopelessly underwater on a car loan. Since the lender will no longer hold the title once the automobile is sold, you will need to take out a loan or pay the debt in full.
To sell the car in a way that benefits your finances:
Utilize the procedures explained above to calculate the size of your negative equity.
Find a way to pay the lender the remaining debt. This might be a loan, but without a car to offer as collateral, it might be difficult to receive an unsecured loan. Most banks require a decent credit score in order to qualify for an unsecured loan. Members of credit unions might fare better. Family, friends, using a credit card, and taking a loan against your 401(k) are further alternatives. Before choosing one, carefully weigh your options as they all have disadvantages.
Selling the car privately could result in a better price than doing it through a dealer. Private sales typically produce higher results than trade-ins, especially if the vehicle is in good condition. Look considering selling the automobile rather than trading it in, even if you plan to purchase a less expensive or used vehicle.
Consider using public transit instead of buying a new vehicle after you sell your old one. Although this isn’t a possibility in many parts of the country, if it is, you can pay down the remaining balance on your loan or start saving for a down payment with the money you save on car maintenance, insurance, and gas.
Advice on How to Avoid an Upside-Down Auto Loan
The easiest method to prevent taking out a car loan that you cannot pay is to avoid doing so in the first place. Make sure you do your homework before you purchase a vehicle to determine the best value for the desired make or model as well as the cost of options, financing, and taxes.
Your best alternative may be to purchase a secondhand car, according to the research. Used vehicles with a recent model year and low mileage are a wise investment. The purchase price should be at least 20% less than the original cost because the initial owner will have already paid the cost of depreciation in the first year.
When making a purchase, don’t just look at the sticker price; but take into account the monthly payment, which should include interest, taxes, and additional fuel expenditures if the vehicle is larger or less fuel-efficient. The amount that affects your daily budget is that one.
Use the 20-4-10 guideline when purchasing a new vehicle: 20% down payment, 4-year (or less) loan term, and a monthly car payment plus insurance that doesn’t exceed 10% of your gross income. If those calculations don’t add up, consider looking at secondhand cars.
The following advice can help you stay out of an upside-down vehicle loan whether you’re buying a new or old car:
Taxes and fees: When you purchase, pay them in full rather than adding them to the loan balance.
Repayment Schedule: Pick the quickest repayment schedule you can manage. It will be repaid more quickly and at a cheaper interest rate. For instance, paying $1,372 in interest over the course of a three-year, 3.5% loan for $25,000 with a credit score of 661 or higher. It would cost $1,827 over four years. The cost of a five-year loan is $2,287. The interest rate increases when your credit score declines. With a 6.07% interest rate and a credit score between 601 and 660, a three-year loan would cost $2,408 in interest; a five-year loan would cost $4,048. In 2022, the typical borrower had a $39,340 loan with a 60-month term and a 5.2% interest rate, costing $5,420 in interest.
Down Payment: Make a 20% or more down payment as a minimum to cover the immediate depreciation.
Depreciation: To determine the value of the car and which models hold their value better over time, research values on Kelley Blue Book and Consumer Reports. By doing this, you’ll avoid paying too much and guarantee that your automobile will be worth more when you sell it or trade it in. You might initially be underwater if you intend to retain the automobile for longer than the loan’s term, but as you make loan payments, your equity will increase. It will also assist retain value when you sell the automobile if you keep up with routine maintenance and keep it clean and in good shape.
Leasing vs. Buying: If you intend to retain an automobile for fewer than three years, leasing may be a better option. With a lease, you have no debt, thus you can’t be in the red. Make sure you understand the lease’s terms; if you drive a lot, the mileage fees may make the leasing more expensive than purchasing.
Rewards: Look for dealerships that provide monetary rewards that offset the 20% depreciation.
Pay Off: Before you sell or trade in your car, pay off your loan.
Loans for People with Bad Credit: If you’re looking for a car loan but have bad credit, check out personal loans from internet lenders, credit unions, or consider a home equity loan. They might provide interest rates that are lower than a dealership.