When you finance a car, you can eventually run into the problem of having an upside-down car loan where your loan balance exceeds your car's value. This can result from issues such as experiencing significant decreases in your car's value in the early years of ownership or having rolled over the balance of a past car loan into your current one. While you could just keep paying the car loan until the term ends, you can consider different ways to refinance or reduce the car loan or even get rid of the vehicle. Take a look at all you should know about negative equity for a car loan and options for escaping the situation.
Recapping Some Auto Loan Basics
Taking out a car loan involves borrowing money to pay for your car's sale price plus extras you might decide to roll into the loan like taxes, extended warranties, gap insurance and vehicle upgrades. The amount you need to borrow gets reduced by the money you put down toward the vehicle and any trade-in value you receive as well as any associated costs you decide to pay for out of pocket. For example, you might make a $2,000 down payment, get $5,000 in trade-in value for your old car and then pay all the taxes and fees upfront to reduce your debt.
While you might borrow $30,000 for a vehicle, you'll usually pay much more than that over the course of the two to seven years that a car loan usually lasts. That's because the lender will charge you interest in most situations – an exception is if you can find a 0 percent financing special – and the interest rate can be low or high depending on your credit profile, the length of the loan and the type of car you're borrowing. The Consumer Financial Protection Bureau (CFPB) warns that car buyers with poor credit can especially end up with high interest rates that can make the vehicle's real cost increase significantly.
Each month during repayment, the money you pay will partially go toward the principal and partially toward the interest. While some lenders come up with a precomputed payment so that you have equal monthly payments the whole loan term, others calculate the payment monthly based on the principal remaining at that time. This means that the money saved paying off a car loan early depends on how the lender calculates interest. When payoff does occur, you own the car outright and no longer have the lender's claim on the vehicle.
Read More: How to Get a Car Loan
Defining an Upside-Down Car Loan
Ideally, you'd want to not owe any more for your car loan than your vehicle's worth. However, this isn't always the case since many factors can lower your vehicle's value or slow down the process of paying down your loan's principal balance.
You calculate the equity you have in a vehicle by finding the difference between the current loan principal amount and the current market value of the car. A car has positive equity when it's more valuable than the loan balance, while it has negative equity and is considered upside-down when the loan balance exceeds the value.
Reasons for Upside-Down Car Loans
You can end up with an upside-down car loan simply due to the effect of depreciation, which makes your car's value fall over time and has a strong effect within the first few years of ownership. According to research done by the firm iSeeCars, you might find that your car's value drops 20 percent during the first year alone and falls almost 50 percent within five years, but this depends on the vehicle model and condition. Considering how a car's value falls, this factor alone can lead to an upside-down car loan unless you made a large down payment or pay down the car loan faster than expected.
You can also end up with an upside-down car loan due to rolling car loans into each other or taking out a car loan with a very long term. For example, you might have decided to trade-in a car that still had a loan on it, and the lender let you roll the amount over and add it to the new vehicle's loan amount. In that situation, you have just the new car but are paying for two cars, one which you don't have anymore. Further, a very long loan term comes with lower payments that make it harder to pay down the balance at a rate that can keep up with your car's decreasing value, so this can get you underwater on your car loan.
In other cases, you might have paid more for a vehicle than it was worth in the first place. This can happen if you buy from a dishonest car dealer.
Read More: What Does a Car's Black Book Value Mean?
Assessing Negative Equity and Options
You have several options for escaping an upside-down car loan, but your options will depend on your financial situation, the negative equity amount and your desire regarding whether to keep the vehicle. For example, if you want to keep the vehicle, you could look into options like refinancing the loan, paying money toward the loan to get rid of negative equity or finding other ways to reduce the amount due. If you want rid of the car, you'll focus on getting the best price for your vehicle and finding out how to handle the difference between the sale price and your loan balance.
In any case, you should first start by calculating how much negative equity you have. You can either take a look at your current car loan balance on your lender's website or contact them for the quote. Once you know what you owe, try using tools like the Kelly Blue Book or Edmunds websites to learn about the current resale value on the private market. Keep in mind that the CFPB warns that simply contacting dealerships to find out the trade-in value usually will yield a lower number than the actual value, so it doesn't recommend that approach.
You can then calculate the difference between the car value and loan amount to determine the negative equity. For example, if you owe $17,000 on a car with a value of $12,000, then your negative equity is $5,000. Keep in mind that as your car's value decreases further and doesn't catch up with your slowly decreasing loan balance, the negative equity can continue to go up.
Considering Trading or Selling the Car
If you want rid of the vehicle and the loan, you can attempt to sell or trade-in the vehicle, but this won't get you out of the loan itself. Instead, you'll need to take the proceeds from the sale or trade-in and use it toward your loan. You can then either use cash you have on hand or use another form of credit to help pay off the rest of the car loan.
When you choose this method, you'll want to find where you can get the best price for your car. This often means finding a private buyer versus selling the car to a dealership. If you plan to borrow money to pay off the remaining balance after the sale or trade-in, look for options that have low interest rates, make sure you can fit the payment into your budget alongside any new car payment and try to pay off the debt as soon as possible to minimize interest charges.
Alternatively, you might consider working on paying down the loan until it's no longer upside down and then getting rid of your car when you can pay off the remaining loan balance.
Read More: Can You Sell a Vehicle You Just Bought?
Refinancing Your Auto Loan
Depending on how much cash you have, what your credit looks like and how upside-down your car loan is, you might be able to get in a better situation through refinancing your auto loan. Going this route would involve first paying the underwater amount toward your existing car loan so that you don't owe more than what the car's value is. This is important because lenders usually won't want to give you a new auto loan with higher than a 100 percent loan-to-value ratio.
You can then look into refinancing through your current lender or shopping around for other options. When doing so, carefully research so that you can get a new car loan with a lower interest rate and reduce the chance of being underwater again. The old auto loan would be paid off, and you'd make payments toward the new one. For this to benefit you, you'll need to carefully choose a loan term – preferably as short as possible – and have good credit to achieve a better interest rate than you already have.
Read More: What Does Refinance Your Car Mean?
Looking Into Removing Add-ons
When you bought your car, you might have opted for extra services the dealership advertised and then rolled those into your loan with everything else. For example, dealerships will often sell extended service contracts, paint and fabric protection, gap insurance and tire warranties. These can add up to thousands of dollars above your car's price and lead to a significantly higher loan balance that exceeds your car's value.
The good news is that you can cancel many of these items for at least a partial refund, especially if you haven't taken advantage of any benefits yet. You'll usually get a prorated amount back unless you cancel very close to the time when you purchased the car and add-ons, and the refund should go back to your car loan and help you be less underwater. The papers you got with your car should include the terms and contracts for add-ons.
However, you'll want to carefully weigh the pros and cons of getting rid of specific add-ons. For example, you might want to keep your gap insurance with an upside-down loan in case you have an accident.
Changing Your Repayment Strategy
If you want to keep both your car and current auto loan but just want to get rid of the negative equity, you have a few options for paying the loan differently. Depending on what you can afford and how quickly you want to stop being underwater, you might either make larger monthly payments, increase the frequency of payments or make a lump-sum payment toward the loan.
Similar to how you would with refinancing, you could just pay the underwater amount at once and then make your loan payments as usual. However, you should keep an eye on your car's value and loan balance to make sure you don't get underwater again. If you can't afford to do this, check with your lender to see about making principal-only payments to help lower the principal plus reduce interest paid and work toward cutting down your loan. This could mean paying an extra $100 a month or even paying two car payments a month, but beware of any prepayment penalty that applies.
Read More: How to Pay Off a Car Loan Early
Deciding to Keep the Loan
If you don't have the money available to pay a large chunk of your loan off and you can't qualify for a refinance, you might opt to keep both your vehicle and loan. As long as you can handle your car payments and can carry on until you've completed payoff, you could deal with the idea of having an upside-down loan, but you should mitigate some of the risks.
Specifically, having a car with an upside-down loan can become a problem if you have a car accident because the insurance company will want to pay for only the car's current market value, not the entire loan amount you owe. Opting for gap insurance can help in this situation since it should pay the leftover amount on your car loan in case your car gets totaled. You might have already gotten this extra coverage when you purchased the car, but you can also contact your insurance company to have it added. Once you're no longer underwater, you can get rid of the gap coverage.
- Consumer Financial Protection Bureau: What Is Negative Equity in an Auto Loan?
- Consumer Financial Protection Bureau: I Owe More on My Current Loan Than My Current Vehicle Is Worth. What Do I Need To Know if I Buy a New Vehicle?
- Federal Trade Commission: Auto Trade-ins and Negative Equity
- Consumer Financial Protection Bureau: Worried About Making Your Auto Loan Payments? Your Lender May Have Options That Can Help
- LendingTree: Upside-Down Car Loans: 7 Ways to Get Out of an Upside Down Car Loan Fast
- Dave Ramsey: How to Get Out of an Upside-Down Car Loan
- Credit Karma: When Does Refinancing a Car Loan Make Sense?
- Insurance Information Institute: What Is Gap Insurance?
- Federal Trade Commission: Financing or Leasing a Car
- Consumer Financial Protection Bureau: What Is a “No Credit Check" or “Buy Here, Pay Here” Auto Loan?
- Credit Karma: How Does Interest on a Car Loan Work?
- iSeeCars: Top 10 Cars That Hold Their Value Best
- Consumer Financial Protection Bureau. "What Is Negative Equity in an Auto Loan?" Accessed July 15, 2020.
- Kelley Blue Book. "Q: What Is Car Depreciation?" Accessed July 15, 2020.
- Insurance Information Institute. "Determining Your Car's Value and Cost of Repair." Accessed July 15, 2020.
- Consumer Financial Protection Bureau. "Servicemembers, Arm Yourself With Basic Car Buying Skills—How to Trade in Your Car." Accessed July 15, 2020.
- Experian. "How Much of a Down Payment Should You Make on a Car?" Accessed July 15, 2020.
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.