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How to Handle an Upside-Down Car Loan

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Upside-down. Negative equity. Underwater. No matter what you call it, it means you owe more on your car than it’s currently worth. While it happens to most people who finance the purchase of a vehicle at some point, it’s not a good place to be — especially when you’re planning on selling the car or trading it in for a newer model.

It’s also a situation that’s becoming more common. According to the Edmunds Used Vehicle Market Report for the third quarter of 2016, a record 25 percent of all trade-ins toward a used car purchase have negative equity, and the average negative equity at the time of trade-in was $3,635 — also a record in the used-car market.

You can find out if you’re in this position by looking up the value of your vehicle using a research tool such as Kelley Blue Book. If the value is less than the balance on your current car loan, you are upside-down.

Part I: How do you get upside-down in the first place?

There are some reasons car loans may be upside-down.

Low down payment

Dealerships often offer incentives for new cars, including very low or no down payment loans. A new car loses about 20 percent of its value in the first year, so a small down payment can quickly cause the balance of your loan to soar above its actual value. A healthy down payment can help keep your loan balance in line with the worth of your car.

High interest rate

Remember to shop around for an auto loan, because the higher the interest rate, the less you’re paying toward principal each month. That makes it more likely you’ll become upside-down, even if you made a decent down payment.

Anthony Curren, a sales and marketing manager and salesperson with Rick Curren Auto Sales in Corning, N.Y., says he sees this happen pretty regularly when disreputable salespeople charge higher interest rates to make more money off a loan.

“This happened to my girlfriend before we met,” Curren says. “She had an 800-plus credit score and got stuck in a loan charging 5 percent interest. She should have been paying 2 percent or less at that time.”

Longer loan term

According to Experian’s State of the Automotive Finance Market report for the second quarter of 2017, the average length of a new auto loan is currently nearing 69 months. While longer loan terms may keep your monthly payment low, you’ll end up paying more interest, and you’re more likely to be upside-down.

Past upside-down loan

You could be upside-down because you carried negative equity over from your last car loan. Many dealers offer what’s known as a rollover loan: When people trade in an upside-down vehicle, the dealership rolls the negative equity into the purchase of their next car. With a rollover loan, you are upside-down before you even drive off the lot.

People who trade up for a new vehicle every couple of years are most likely to have car loans with rolled-over negative equity. In the first few years of a new car loan, your car depreciates faster while your loan balance declines the slowest due to interest. This means many people are upside down in the early years of their loans. The longer you keep the vehicle, the more likely it is that the loan balance will be less than the current value of the vehicle.

Being upside-down on your car loan may not pose a problem, as long as you are planning on holding onto the car until you have some equity in it. But if an unforeseen financial setback means you need to sell the car, you may need to come up with extra cash to pay off the loan difference. And if your car is wrecked or stolen, your insurance may not pay out enough to retire the loan.

Part II: How to get out of an upside-down car loan

The first step to dealing with an upside-down car loan is knowing your numbers.

Step 1: Figure out how much you owe.

The fastest and most accurate way to find out how much you owe on your loan is to contact your finance company. If you are planning on selling or trading in your car right away, you’ll need to know the payoff amount, not just the amount remaining on your principal. The payoff amount is how much you actually have to pay to satisfy the terms of your loan. It includes the payment of any interest you owe through the day you intend to pay off the loan, as well as any prepayment penalties.

You may be able to find this figure by logging into your lender’s online account portal. Otherwise, you’ll have to call the finance company.

Step 2: Figure out how much your car is worth

You can get a value estimate using Kelley Blue Book’s What’s My Car Worth tool. You’ll need to provide the car’s year, make, model, mileage, style or trim level (the alphanumeric code that helps identify at what level the vehicle is equipped), and the car’s condition. If you’re not sure how to rate your car’s condition, you can take a quick quiz to help you assess it.

Once you input those details, you’ll receive a range suggesting how much (or how little) you can expect to receive from a dealer for a trade-in. Keep in mind that every dealer is different, but you may be able to negotiate.

Step 3: Calculate your negative equity

If the payoff amount on your loan is greater than the value of your car, you are, as we’ve said, upside-down. Subtract the value of your car from the payoff amount to find out how underwater you are. If the difference is small, you may be able to make extra payments toward the loan’s principal to catch up. If the difference is significant, you may have to take more drastic steps.

Step 4: Strategize remedies

If you find yourself upside-down on your car loan, the most prudent course of action is continue to pay down the debt until you have some equity in the car. You can hasten the process by making extra payments toward the loan’s principal.

If that isn’t an option, here are a few other ideas.

Pay off the car with a home equity loan or line of credit

As with most things in life, there are pros and cons to paying off a car loan with a home equity loan or line of credit (HELOC). One advantage is that you can typically lengthen your repayment period, thereby reducing your monthly payment. HELOCs also have more flexible repayment options, compared with the fixed monthly payment that comes with an auto loan. This may be a good option if you’re having trouble making your monthly payment due to a temporary financial setback.

The second advantage of paying off your car loan in this fashion: The interest paid on your HELOC is typically tax-deductible, while interest on your car loan is not. Keep in mind that you’ll have to itemize deductions on your tax return to take advantage of this benefit. If you take the standard deduction, there’s no tax advantage.

But before you pay off a car loan with a HELOC, consider the downsides. First off, HELOCs are often variable-rate loans. If interest rates rise, your monthly payment could go up. Second, even if the interest rate on your HELOC is lower than the interest rate on your car loan, you could end up paying more in interest by stretching out the loan term. Finally, if you can’t make your HELOC payments, you could lose your home.

If you decide to take this route, make a plan to pay down the HELOC as soon as possible. Otherwise, it could well outlive your car, and you’ll be paying off the HELOC and a new loan for your next vehicle at the same time.

Pay off the car with a personal loan

Paying off a car loan with a personal loan could be a good option if you plan on selling your car without buying a new one. In that case, you would sell the car, use the proceeds to pay down the balance of the car loan, then refinance the remaining balance with a personal loan.

However, keep in mind that auto loans are secured by collateral (the car). If you’re unable to pay, the lender can repossess the car. Personal loans are unsecured. If you stop paying, the lender has fewer options for recovering the money. For this reason, personal loans usually come with higher interest rates than auto loans.

The Federal Reserve Bank’s survey of commercial bank interest rates for the second quarter of 2017 shows just how much higher those rates can be. The average 60-month new car loan comes with an APR of 4.24 percent. The average 24-month personal loan has an APR of 10.13 percent. So with the typical personal loan, you’ll pay more than twice as much interest in half the time. Hard to see that as a good deal.

Refinance the car loan

Refinancing your car loan can help in a few ways. You may be able to lower your interest rate and lower the term of your loan, both of which will help you get equity in your car sooner. Curren says deciding whether refinancing is the right option depends on the remaining loan term and interest rate.

He uses the hypothetical example of a person who, because of credit issues, used a subprime loan with an interest rate of 22.9 percent to purchase a car. “My advice to that person is to build their credit up as much as possible and as quickly as possible,” Curren says. “In one year, they should be looking at refinancing the loan with an interest rate as low as 6 or 7 percent, which is still relatively high, but much more palatable. It will save them thousands of dollars in repayment.”

However, Curren says he doesn’t offer the same advice to someone with only a year or two left on a loan. “At that point, the savings is minimal,” he says. “The better advice is to pay off the car quicker.”

Part III: What to watch out for when you have an upside-down car loan

Car dealers push the latest vehicle designs and advertise very attractive incentives for trading in your old vehicle, no matter how upside-down you are at the moment. But take heed: You’ll want to be very careful about trading in an upside-down vehicle for a new loan. Here’s a look at the problems that can arise:

Rolled-over negative equity

As we mentioned above, many car dealers are willing to roll the negative equity from your old car loan into a new loan. This is a popular option because it doesn’t require coming up with any money immediately. But it also means your new car will be underwater before you even drive it home. That new car may be fun to drive, but your monthly will be higher because it includes the cost of your new vehicle and the remaining balance on the old one.

Dealer cash incentives

Some car dealers offer cash incentives that can help pay off your negative equity. For example, if you have $1,000 in negative equity on your current car loan, you could buy a new car with a $2,500 rebate, use $1,000 of the rebate to pay off the negative equity, and still have $1,500 left over to use as a down payment on the new car.

But be wary of dealers advertising they’ll “pay off your loan no matter how much you owe.” The FTC warns consumers that these promises may be misleading because dealers may roll the negative equity into your new loan, deduct it from your down payment, or both. If the dealer promises to pay off your negative equity, read your sales contract very carefully to make sure it’s not somehow folded into your new loan.

Part IV: How to avoid an upside-down car loan

Being upside-down on your car loan, at least for a little while, is very common. But there are things you can do to prevent it from happening.

  • Make a larger down payment. Because a car depreciates by around 20 percent in its first year, putting down 20 percent of the total purchase price (including taxes and fees) can help you avoid going underwater.
  • Choose a car that holds its value. Some makes and models hold their value better than others. Kelley Blue Book, Edmunds and other car research sites regularly release lists of car brands and individual models with the best resale value. Do your research and pick out a car that will depreciate more slowly.
  • Opt for a shorter loan term. Longer terms are more likely to leave you underwater in the early years of the loan because you’re paying less toward the principal each month. Try not to finance a car for longer than you plan on keeping it.
  • Shop around for the lowest rate. The lower your interest rate, the more money you’ll pay toward principal each month. Don’t settle for the first offer you receive at a dealership. Shop around for a car loan before you go to the dealer, so you can feel confident you’re getting the best deal.
  • Avoid unnecessary options. Sunroofs, leather upholstery, rust proofing, extended warranties, fabric protection, chrome wheels — all these attractive add-ons are often overpriced. They’ll increase the purchase price of your vehicle, but rarely add long-term value.

Final thoughts

Being upside-down on your car loan is not an ideal situation, but you do have options. Understand the circumstances that led you to be upside-down in the first place can help keep the problem from recurring, or from carrying over to your next loan.

Janet Berry-Johnson
Janet Berry-Johnson |

Janet Berry-Johnson is a writer at MagnifyMoney. You can email Janet here

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