An upside-down auto loan—also known as being “underwater” on a loan—occurs when you owe more on your car loan than the car is worth. This situation can be stressful and financially limiting, especially if you want to sell or trade in your vehicle, but are faced with a loan balance higher than the car’s current market value. Fortunately, there are several strategies to help you get out of an upside-down auto loan. While it may take time and careful financial planning, it is possible to regain control of your car loan and avoid further financial strain.
In this article, we will explore what it means to be upside down on an auto loan, why it happens, and how you can work your way out of this situation.
What Does It Mean to Be Upside Down on an Auto Loan?
Being upside down on an auto loan means that the amount you owe on the loan exceeds the market value of the car. This situation typically arises because cars depreciate quickly, especially new ones. The minute you drive off the dealership lot, the car begins to lose value. If your car depreciates faster than you are paying down the loan, you can easily find yourself owing more than the car is worth.
For example, let’s say you purchase a new car for $30,000 with a $5,000 down payment, leaving you with a loan balance of $25,000. If your car’s market value drops to $20,000 due to depreciation, you would be upside down by $5,000. If you want to sell or trade in the car, you would still owe the lender $5,000 more than you can sell it for.
Why Do People End Up Upside Down on Auto Loans?
There are several reasons why car buyers might end up upside down on their loans:
- Depreciation: Cars lose value quickly, with new cars typically losing 20% to 30% of their value in the first year alone. This rapid depreciation can make it easy to fall behind on paying off the loan compared to the car’s value.
- Small Down Payment: If you make a small or no down payment, you’re starting with a larger loan balance, which can make it more difficult to build equity in the car. The smaller your down payment, the greater the chance that you’ll owe more than the car is worth.
- Long Loan Terms: Longer loan terms, such as 72 months or even 84 months, can make monthly payments more affordable but result in a slower reduction in the principal balance. As a result, the car’s depreciation can outpace the loan repayment.
- Rolling Over Debt from a Previous Loan: Some buyers choose to roll over their remaining loan balance from a previous vehicle into a new loan, increasing the amount financed. This can lead to an inflated loan balance, making it harder to get ahead of depreciation on the new car.
- High-Interest Rates: If you have poor credit, you might be offered a higher interest rate, which means a larger portion of your monthly payment goes toward interest rather than paying down the principal balance. This can prolong the time it takes to reduce the loan balance.
How to Get Out of an Upside-Down Auto Loan
Being upside down on an auto loan is a challenging situation, but it is possible to get out of it. Here are some strategies that can help you manage and eventually escape the financial burden of owing more than your car is worth.
1. Keep Your Car and Continue Making Payments
One of the most effective ways to get out of an upside-down loan is to keep the car and continue making your regular payments. As you continue paying down the loan, your loan balance will decrease, and the car’s value may stabilize. Over time, you can catch up and eliminate the negative equity. However, this approach can take years, depending on how much you owe versus the car’s value.
If you’ve purchased a car with a long loan term (e.g., 72 or 84 months), it may take even longer to pay off the principal balance. The key is to avoid refinancing or selling the car until the loan balance is lower than the car’s market value.
2. Make Extra Payments Toward the Principal
If you can afford to, making extra payments toward the principal of your car loan can help you pay down the loan faster and reduce your negative equity. By increasing your monthly payment or making occasional lump-sum payments, you can accelerate the loan repayment process and reduce the difference between your loan balance and the car’s value. Even small extra payments can help chip away at your upside-down loan balance over time.
Some loans allow you to make additional payments without penalty, so check your loan agreement to confirm. If you’re able to make extra payments, focus on applying them directly toward the principal, rather than the interest.
3. Refinance the Loan
If you have improved your credit score or your financial situation has changed since you took out the original loan, refinancing might be a good option. Refinancing can help you secure a lower interest rate or a more favorable loan term, which could result in lower monthly payments or a faster loan payoff.
However, refinancing alone may not be enough to eliminate negative equity. If you’re still upside down on the loan, it might be beneficial to combine refinancing with additional payments toward the principal to reduce your loan balance.
4. Consider Trading in the Car for a Less Expensive Vehicle
If you’re still upside down on your loan and need to get out of the car, trading it in for a less expensive vehicle might be an option. However, keep in mind that if your car is worth less than your loan balance, you will still need to cover the difference (the “gap”) between the trade-in value and the loan balance. Some dealerships may offer to roll this difference into the new loan, but this could simply prolong the problem.
If you choose to trade in the car, make sure you fully understand how much you owe versus the trade-in value before proceeding. If you have GAP insurance, it may cover part of the difference, making the trade-in process less financially burdensome.
5. Sell the Car and Pay Off the Loan
Another option is to sell the car privately, which might allow you to get a better price than the trade-in offer from the dealership. If the car’s market value is lower than the loan balance, you will need to cover the difference with cash to pay off the loan in full. Selling your car privately may take time, but it could be worth it if you’re able to secure a higher sale price.
If you are unable to sell the car for enough to cover the loan balance, you may still have to find a way to pay the remaining balance out of pocket. However, this may allow you to escape the car and stop making payments on it, freeing up funds to pay off the loan faster.
6. Ask for a Loan Modification
If you’re in financial distress and struggling to make car payments, contacting your lender to discuss the possibility of modifying your loan may be an option. A loan modification could involve adjusting the interest rate, extending the loan term, or temporarily reducing your monthly payments. While this won’t eliminate negative equity, it could help ease the financial burden and give you more time to pay off the loan.
If you have a good relationship with your lender, they may be willing to work with you on modifying the loan terms to prevent default or repossession.
7. Consider a Voluntary Repossession
As a last resort, if you’re unable to keep up with the car payments and can’t afford the loan balance, you might consider a voluntary repossession. This involves returning the car to the lender to avoid a forced repossession. While this will still negatively impact your credit score, it can prevent further damage, such as having the car repossessed without your consent.
Before going down this path, be sure to understand the financial and credit implications. You will still owe the remaining loan balance after the car is sold at auction, and this debt will need to be settled. This should be considered only after exploring all other options.
Conclusion
Being upside down on an auto loan can feel like a financial trap, but there are several strategies to help you manage and eventually escape this situation. Whether it’s making extra payments toward the principal, refinancing, or keeping the car and sticking with the loan, it’s important to take proactive steps to reduce negative equity. The key is to act sooner rather than later, as prolonged negative equity can lead to further financial strain.
If you’re in an upside-down loan situation, consider your options carefully and choose the approach that best fits your financial goals. With time, planning, and persistence, it’s possible to get out of an upside-down auto loan and regain control of your finances.