- When you are upside down on your car loan, you owe more money on your vehicle than it’s worth.
- Small down payments and long loan terms make it easier to go upside down on your loan.
- Consider refinancing your car loan or contributing more money per month to reduce negative equity.
- Read more of Personal Finance Insider’s loan coverage here.
Because most cars lose value quickly after you buy them, you might be upside down on your car loan. Luckily, there are options to help you get out from underneath this financial burden.
What is an upside-down car loan?
When you are upside down on your car loan, you owe more money on your car than it’s worth.
Let’s say you took out a car loan of $20,000 with a five-year term and a 5% interest rate. However, the value of your car will depreciate as soon as you leave the lot. After two years, you still owe around $12,000 on your loan, but your car is only worth $10,000. This means you are upside down, also called having negative equity, by $2,000.
If you want to get rid of your car, you have to pay the lender the negative equity on the vehicle in addition to the amount you sell or trade it in for.
Going upside down on your loan isn’t inherently a bad thing, but it can cause trouble if you run into certain situations.
For instance, if your car is totaled, your insurance company will only pay for the estimated value of your car. If you’re upside down on your loan, you’ll owe the lender your negative equity, which could be thousands of dollars out of pocket. Or say you want to transition from your current car to a different one. You’d have to pay the amount you owe above the trade-in value of your original car to trade it in.
How do upside-down loans happen?
Upside-down loans are often a result of the terms you choose when you buy your car. Here are some of the most common reasons.
- Little or no money down. Cars lose a percentage of their value almost immediately when you drive them off the lot, and if you don’t make a down payment, you may instantly be upside down on your loan. With no money down, you’ll also end up financing the taxes, licensing, registration, and dealership fees, which will add to the total cost of the loan and leave you already owing more than the car is worth.
- Loans with long term lengths. Dealers may offer term lengths as long as eight years, but your payments might not be able to keep up with depreciation. The longer the term, the more money you’ll pay in interest. Keep in mind that shorter term lengths come with higher monthly payments, though.
- Overpriced cars. Do your research on similar makes and models and shop around at different dealerships to find the best deal possible. If you jump at the first offer you find, it could end up costing you thousands of dollars in the long run and may expedite going upside down on your loan.
- Unnecessary add-ons. The dealership might pressure you into buying things like extended warranties, sunroofs, or DVD players, as they make a lot of money on these add-ons. However, every additional purchase you make means you’ll have less money to put toward the car.
How do you get out of an upside-down loan?
Start by figuring out how much you owe on your car. To calculate this figure, subtract your car’s value from your outstanding loan balance. The Federal Trade commission recommends looking at National Automobile Dealers Association Guides, Edmunds, and Kelley Blue Book to estimate what your car is currently worth.
Then, you may consider refinancing your car loan. You could be eligible for a lower rate and a shorter repayment term length when you refinance, which would shorten the amount of time it takes to get you out of negative equity on your loan.
If you have enough money, you might want to pay off your negative equity in a singular lump sum payment — though check with your lender to make sure you won’t incur any early payment penalties. You probably don’t want to completely drain your bank account to do this, though, as you’ll want to have money on hand in case of emergencies.
You could also contribute more per month by rounding up your payments to the nearest $50, for example. You’ll pay off your loan and get rid of your negative equity more quickly.
Read more of our tips to pay off your car loan faster.
Selling your car privately via marketplaces like Craigslist or Ebay is another option to consider. You should try to get enough for the car to clear your negative equity, otherwise you’ll have to pay that money back yourself.
Finally, you may think about trading in your car at the dealership, but exercise caution before you do so. If you’re not careful, you could immediately end up with negative equity on your new car and fall into a cycle of debt. However, you could potentially be clear of your negative equity if you can downgrade and find a car worth more than its price.