How to Handle an Upside-Down Car Loan

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Updated on Saturday, August 29, 2020

Having an upside-down car loan means you owe more than the car is worth — it’s also called having negative equity. This means that if you decide to sell or trade in your car before the loan is paid in full, you may have to add the balance to the loan of your next vehicle.

There are, however, ways to avoid getting upside down in the first place, or improve your financial situation if you want to get rid of the vehicle before it’s paid off.

Determine if you have an upside-down car loan

Being upside down in a car loan is becoming more common, as cars become more expensive and loan terms get longer. In April 2020, the share of new car sales with a trade-in involving negative equity hit 44%, and the average amount of negative equity reached $5,571, according to Edmunds. The average cost of a new car has risen to $39,000, making it more likely people will take long-term loans up to 84 months or more, said Ivan Drury, senior manager of insights at Edmunds.com. Here’s how to figure out if you’re underwater on your car loan, and if so, by how much.

Step 1: Figure out how much you owe

Ask your lender for the payoff amount. The payoff will be more than the loan balance because it includes interest until the time you completely pay the loan and any prepayment penalties. The payoff amount is usually calculated for a period of time as determined by the lender (such as within the next 10 to 15 days, as an example). If you wait longer than that, the payoff amount will change.

You may be able to request a payoff amount through your finance company’s website. If not, you will have to call them directly.

Step 2: Look up your car’s value

Use online sites such as Kelley Blue Book or NADAguides to find your car’s trade-in value. Some sites will also provide an average figure for a private sale in addition to the trade-in value.

Online car-buying sites such as Carvana, Vroom and Shift will also provide a value — and unlike valuation sites like Kelley Blue Book and Edmunds, these sites will actually purchase your car. Selling an upside-down car to CarMax or other physical dealer is a possibility, too. Each site or dealer will likely give a different price, so the actual amount will be unknown until you talk to a dealer about a trade-in or sell it yourself.

You’ll need to know the car’s make, model, year, trim level and mileage. You’ll also be asked to rate your car’s condition, which can be subjective — one person’s excellent might be another person’s average. Use an online quiz, like the one KBB offers, to describe the condition of your car accurately.

Step 3: Calculate your negative equity

Calculate the negative equity to figure out how much you owe compared to the car’s value. Use your best estimate for the car’s value to compare against the payoff amount.

Subtract the estimated value of your car from the total balance you owe. For example, if the value of your car is $22,000, but you owe a $25,000 balance, you are $3,000 underwater on your loan.

Once you figure out if you’re upside down, you can develop a plan about what to do next.

How to handle an upside-down car loan

There are two basic strategies you can use to improve your situation if you find yourself in an upside-down car loan. You can continue making payments until the loan is paid off, or you can sell or trade in the car. It’s not impossible to get out of an upside-down car loan, but it could be costly.

Refinance to a new loan

One way to handle an upside-down car loan is to refinance into a new loan. Perhaps your financial situation has improved, and your credit score is higher now. You could refinance with a lower interest rate, which reduces the amount you will pay for the car. However, if you’re upside down, you’ll have to finance the negative equity in the new loan, which will increase the amount of money you’ll need to borrow, or pay off the difference upfront. Before choosing this option, make sure that you can afford the payments on a new, higher loan amount.

Sell your car

You can sell your car and use the proceeds to satisfy the loan. If you’re upside down, you’ll have to add some cash to equal the loan payoff amount. You can sell your car to a private party or use an online car-buying service. Either way, the buyer will pay you directly, and it’s your responsibility to send the money to your lender.

Trade in your car

You can trade in your car at the dealer when you buy another vehicle. If you’re upside down on the loan, the dealer may add the balance to the new car loan or deduct the amount from any down payment you make. If you decide to lease your next car, you can roll the negative equity into the lease payment.

Fair warning, however: If the dealer advertises that they will “pay off your loan no matter what,” you should tread carefully. A deal like that means they will take care of paying the balance to the lender, so the lien is satisfied for the trade-in. They won’t pay off your loan out of the goodness of their heart, though. You’ll still be on the hook for the difference between what your car was worth and what you owed on the loan. The dealer will add the balance from your upside-down loan to your new loan.

The Michigan Attorney General’s office warns consumers to make sure they understand how the dealer will pay the loan, such as in a lump sum or monthly. This is important because regardless of what a dealer tells you, your name is on the loan paperwork, and you are thus responsible for satisfying payment on it. If a dealer pays off the loan monthly, any late payments they make could impact your own credit, since your name is on the paperwork. It’s best to get the terms of payment for your old loan in writing, to protect yourself from any potential problems down the road.

Avoid multiple loan rollovers

Say you have a two-year-old car with a loan term of 72 months. You decide that you want to trade in that car for a new minivan, for example. Imagine that your loan payoff is $25,000, but the dealer will give you only $22,000 for your trade-in. That means you have $3,000 in negative equity. For your new car, say you borrow $30,000. But then the dealer adds your negative equity to the loan amount, so you end up borrowing $33,000. That will make your monthly payment higher than it would be without the negative equity, since you’ll need to take out a larger loan. If you decide to trade in the new car in a couple of years without paying it off, you could end up with even more negative equity and wind up even more upside down. You may not even be approved for a new loan.

“Depending on how much they’re willing to give you for the vehicle’s value, you may or may not get approved,” Drury said, noting that a vehicle could be valued very low, resulting in a high loan-to-value ratio, such that obtaining a loan could be especially difficult.

Ride out your current loan

Unless you really need a new car — maybe your family is expanding and you need a minivan — pay off your current loan. Then, you can have the freedom to sell or trade it in and use the equity of the car any way you want, or at least keep an eye on your equity situation. Hopefully, at some point in the life of the loan, you will have positive or neutral equity and can trade in the car.

How to avoid an upside-down car loan in the future

Make a larger down payment

New cars depreciate about 30% in the first year, then about 8% and 7%, respectively, in each of the next two years. If you put down 20% of the total purchase price, including taxes and dealer fees, you can reduce your loan amount so you’re not underwater.

Choose a car that holds its value

Some makes and models hold their value better than others. Car research sites like Kelley Blue Book and Edmunds publish lists of car brands and models with the best resale value. Look for a car that won’t depreciate as quickly as others.

For example, KBB predicts that most 2020 models will retain only 37% of their value after five years, though it also notes that the 2020 Toyota Tacoma will retain as much as 61% of its MSRP after five years of ownership. The higher the estimated resale value in five years, the better chances you have of avoiding an upside-down car loan.

Opt for a shorter loan term

While the average new car loan term is now about 70 months, according to Experian, choosing a shorter term will reduce the amount of interest you pay. With a longer-term loan, you pay less toward the principal each month. That leaves a bigger balance that may exceed the value of the car. It’s a good idea to finance the car for only as long as you intend to keep it.

Shop around for the lowest rate

Use online tools to shop for the lowest interest rate available to you, as it’ll help you pay more toward the principal each month. Shop around for a car loan before you go to the dealer — that way, you can compare rates and feel confident you’re getting a good deal.

If you qualify for an incentive, 0% or another very low rate, you are effectively refinancing your negative equity at that rate, Drury said. For example, say you owe $30,000 on your car, but the value is $27,000. If you trade it in on a new vehicle with a 0% incentive rate, you are financing the $3,000 negative equity at 0% instead of a standard interest rate.

Avoid add-ons

Whenever possible, avoid add-ons, especially those added by the dealer. As you’re finalizing the purchase, the dealer will present you with options such as fabric protection, extended service contracts, nitrogen in the tires and so on. These will add to the cost of the vehicle, but they don’t add to the value of the car. You can also opt for a lower-level trim package that doesn’t have a sunroof, leather upholstery or custom wheels, though this will lower the car’s resale value.

Consider leasing

Leasing terms are shorter than most loans for new cars, so if you plan on keeping a car for just two or three years, leasing might be a better option. However, leasing does have its drawbacks, such as not building equity in the vehicle.

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