How to Get Out of an Upside-Down Car Loan
If you’re upside down on your car loan, you owe more on your vehicle than it’s currently worth. But while dealing with an upside-down car loan can put you in a stressful financial position, there are ways to get back to positive equity. Here’s what you need to know about how to get out of an upside-down car loan.
What is an upside-down car loan?
An upside-down car loan happens when your car is worth less than what you owe on it — this is also known as negative equity or being underwater on the loan. In order to trade in or sell your car and take out a new auto loan, you’ll have to pay off the difference first.
Let’s say your car is worth $10,000 but you still owe $12,000. In this case, you’re upside down on your loan by $2,000 and will need to pay off that amount in order to sell or trade in your car.
How upside-down car loans can happen
It can be easy to end up with negative equity. You might find yourself underwater on your car loan if any of the following scenarios apply to you:
To save money, some car buyers choose to buy a car with no down payment. If you don’t put money down on a car, you end up financing not only the price of the vehicle, but the taxes, licensing, registration and fees — this can make your amount financed larger than the value of the vehicle. Aside from helping you maintain positive equity, a healthy down payment can decrease your monthly payments and the amount you pay in interest over the life of the loan.
Long-term auto loans can sound tempting to consumers working with budget constraints since they result in smaller monthly payments. But an auto loan with a long repayment term can spread out payments so much that a car loses its value faster than you can pay down the loan. Plus, the longer the loan term, the more you pay in interest. It’s a good idea to choose the shortest loan term you can comfortably afford.
Typically, cars depreciate in value by 20% within one year of ownership. After another four or five years, the vehicle depreciates another 15% to 20%. The more a car depreciates, the more its value will drop. If your make and model drops in value too quickly, you’ll end up owing more than you could sell it for.
If you pay more for the car than it’s worth, you’re in danger of being upside down on your car loan. Compare car prices from different sellers to find the best deal. Keep in mind that the cost of a car includes more than just the balance — you’ll also need to account for taxes, fees and interest.
In some cases, your lender may offer to combine your negative equity with your new auto loan. While this strategy can help you get a new ride, you’ll start off with a loan that’s already upside down.
How to get out of an upside-down car loan
Before you can begin the process of getting out of an upside-down car loan, you’ll need to calculate your negative equity. To do this, subtract the value of your car from the amount you still owe. You can determine your car’s value by using industry guides like Kelley Blue Book or Edmunds.
Once you’ve calculated your negative equity, you can move forward with one of the following strategies.
If you’re upside down on your loan, take steps to pay off your loan faster. If you have enough room in your budget, make extra payments to speed up the repayment process. This can also help you save money on interest over the lifetime of the loan.
Another option is to save up and pay off your loan in one fell swoop with a lump sum. Paying off your loan before the term is up can help you save money, but be sure to check your loan contract to be sure you won’t owe a prepayment penalty.
If you don’t have the extra income to pay your car loan off faster, you might want to refinance your car loan. This means taking out a new loan to pay off your original auto loan, ideally with better terms and lower interest rates.
While refinancing your car loan won’t eliminate your negative equity, it can make paying off your car loan easier, especially if you qualify for lower annual percentage rates (APRs) than you’re currently paying. To see how this strategy could help you, use an auto refinance calculator to determine how much you could save.
If you want to downsize into something less expensive, consider selling your car. While you might get enough money from a private sale to cover both your loan balance and the negative equity, there is still a chance you could owe on your car.
Keep in mind that selling a car when you still have a loan can be complicated, especially with negative equity. Before you sell, it’s a good idea to talk with your lender about what’s required of the sales process.
Surrendering your car means giving the vehicle back to the lender. While giving up your car isn’t ideal, voluntary surrender is a much better option than car repossession.
If your lender repossesses your car and the sale doesn’t cover the remainder of your loan, you may still be held responsible for the remaining balance. Plus, repossession can significantly hurt your credit score.
How to avoid an upside-down car loan
During the vehicle-buying process, there are multiple strategies can help you avoid an upside-down car loan:
- Offer a larger down payment: When buying a car, be sure to follow the 20/4/10 rule — this dictates that you should offer a down payment of at least 20% of the car’s value. Even a few hundred dollars can fend off negative equity and help you stay right-side up.
- Choose a short repayment term: The 20/4/10 rule also suggests a loan term of no longer than four years to avoid negative equity. A short-term car loan means you’ll pay less in interest over time and pay off the loan more quickly.
- Avoid unnecessary add-ons: Some salespeople may pressure you to accept unnecessary add-ons, like an extended car warranty. If you finance add-ons, you risk inflating your loan beyond your car’s value. However, some add-ons can actually prove helpful when it comes to getting out of an upside-down car loan. GAP insurance, for instance, covers the value of your negative equity if your car is totaled or stolen.
- Shop around for rates: As with any financial product, it’s important to compare rates, terms, amounts and fees with at least three lenders before signing on the dotted line. By getting an auto loan preapproval from a few lenders, you’re more likely to get your lowest APR and save money on your loan.
- Buy a used car: New cars may come with more bells and whistles, but used cars tend to be much more affordable and hold their value better. When comparing new and used cars, be sure to keep your budget in mind and be realistic about what you can and can’t afford. A new car can still be a great option, assuming you can afford a reasonable down payment and short loan term.
- Pay taxes and fees upfront: Instead of lumping taxes and fees into your car loan, save up to pay these charges upfront. This could save you money and reduce the balance of your loan.