A loan secured by a collateral that has depreciated in market value and is worth less than the balance owed. For example, if you owe $5,000 on a car that is only worth $4,000, the loan is upside down.
With an upside-down loan, the collateral that secured the loan is worth less than the money owed on it. This is relatively common during the early years of car loans because cars depreciate so rapidly that it is easy to owe more on a car than it is worth. Borrowers can also be upside down on a mortgage due to a combination of falling home prices and lack of equity.
How it happens
Upside-down loans are most common in auto loans. New cars are not necessarily a good investment. As soon as you drive your new car off the lot, its value drops significantly. Therefore, it is common to owe more on a car than it is worth in the first couple of years, and the longer the term on your loan, the longer the period of time you will be upside down.
A long-term loan can be tempting. It is appealing to keep your monthly car payments as low as possible. However, since you pay so little toward principal each month, you pay a lot of extra interest. And, since you are not paying down as much of the principal, so your loan becomes upside down quickly. Later, when you go to trade-in the car, you may find that you owe the lender a few thousand dollars even after the trade-in.
How to avoid an upside-down loan.
There are a few things you can do in order to avoid owing more than your car is worth. You can get pre-qualified for an auto loan before you go car shopping.
Chances are you can find a much better rate and term than the car dealer would offer you, and that can help. Another option is to use a home equity loan rather than a car loan to buy your vehicle. You probably can get a much better interest rate since the loan is secured with your home, and the interest should be tax deductible. With this option, keep in mind that the equity you borrow will no longer be available to you upon the sale of your home. Also, think about making a large down payment that will cut the size of your principal and reduce the likelihood that you will end up with an upside-down loan. Finally, be smart. Don’t overspend on a car. It will not keep its value, and you are only in it for limited time. Buy what you can afford so that you are not tempted by terms that quickly turn into an upside-down loan.