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What is an upside down loan and how to avoid it

upside down in a loan

You can avoid upside down loans and underwater loans by maintaining positive equity in your assets, making larger down payments, and getting a short repayment period on the car loan.

It’s not unusual for car owners to go underwater on their loans. In fact, most car owners end up  owing $5,500 on their trade-in!

Keep reading to learn more about how to avoid upside down loans. 

What Does Upside-Down in a Loan Mean?

Upside-down loans are usually in reference to the state of an individual’s car loan. Being upside-down on a loan means a vehicle owner’s car is worth less than their remaining loan balance. 

Another way to think of an upside-down car loan is to think of a person’s vehicle having negative equity. Negative equity in a car means that the vehicle’s market value is worth less than the remaining balance on the vehicle owner’s car loan. Vehicles that have positive equity are worth more than the car owner’s current car loan balance.

Why You Might Have an Upside-Down Car Loan 

How might someone end up with upside-down auto loans? Below are some common reasons why people may find themselves dealing with upside-down installment loans

You Got a Bad Car Loan Deal

A car loses 20% of its value as soon as it’s driven off the lot, so getting a good deal on a car purchase is important if you want to avoid an upside-down loan. Before purchasing a vehicle, check its value to ensure the offering price is appropriate. 

You Didn’t Make an Initial Payment

Some car dealerships try to entice consumers into car purchases with flashy zero money-down offers. While this may seem convenient upfront, it will cause your principal loan balance to rise significantly, causing the loan to take longer to fully pay off. 

High-Interest Rates on Auto Loans

Interest costs are one of the most common reasons people end up with upside-down auto loans. If your interest rates are extremely high, you may end up with a balance that actually increases each month. 

You Extended the Terms on Your Car Loan

The longer you take to pay off your auto loan, the more your car will depreciate in value before you pay it off. If you extend the terms on your loan to make your monthly payments more manageable, you may be putting yourself at risk for upside-down auto loans. 

You Were Enrolled in a Car Loan Rollover Program

Similar to extending payback terms, rollover programs also lengthen the time it takes for borrowers to pay off their loan balances, increasing the chance that their loan will become upside-down.  

You Bought a Car That Was Too Expensive

Luxury vehicles are nice, but they aren’t for everyone. Purchasing a vehicle that is too expensive increases the likelihood of you extending your loan terms or making other moves that will delay the payoff of your auto loan. 

How To Calculate the Equity in Your Vehicle

Follow these 3 steps to calculate the equity in your vehicle:

StepDescriptionExample
1Determine What Your Car Is Worth
Use resources like Kelley Blue Book or the National Automobile Dealers Association to find the current market value of your vehicle.
Let’s say the current market value is: $15,000
2Find Out the Current Balance of Your Auto Loan
Check your most recent statement or contact your lender to find out the exact amount you still owe on your car.
Current balance owed: $18,000
3Calculate Equity
Subtract the amount you owe (Step 2) from the current market value of your car (Step 1). If the result is positive, you have positive equity. If the result is negative, you have negative equity (i.e., you are upside-down on your loan).
Equity: $15,000 (value of car) – $18,000 (amount owed) = -$3,000 (negative equity)

What To Do When You Have an Upside-Down Auto Loan

If you find yourself in a situation where you have an upside-down auto loan, it’s important to act quickly. The faster you rectify the problem and get your finances back in order, the better! 

Determine How Much Negative Equity You’re Dealing With

The first step in getting out of an upside-down automobile loan is to determine how much negative equity the vehicle actually has. To calculate the negative equity, compare the value of your vehicle against how much you currently owe on it; the difference is the negative equity. 

Reach Out to Your Auto Lender

Next, contact your lender and update them on your situation. Discuss the repayment options on your existing loan and see what your lender can do for you. 

Below are a few options you may consider: 

  • Auto Loan Refinance – Consider refinancing your existing car loan for a new one. You may be able to get an auto refinance through a credit union, bank, or private direct lender. And it may be possible to get money when you refinance a loan
  • Sell Your Vehicle – You may be contemplating whether to sell or keep your car. It may be better to sell if you think you can get back a majority of your auto loan balance. If not, you will be left to pay the difference to officially be clear of your upside-down car loan. 
  • Debt Consolidation Loan – If you have other debts besides your upside-down vehicle loan, consider a debt consolidation loan. A personal loan from a direct lender can be a great way to reduce the amount of payments you make each month on your debts. However, beware of predatory lending products such as instant payday loans online.
  • Voluntary Surrender (Last Option Only) – As a last resort, you may also consider simply giving your vehicle back to the dealership/lender. This action would offer you no money and leave you without a car, which is why you should only voluntarily surrender your vehicle when there is absolutely no other option left.

Don’t Stop Making Your Monthly Auto Loan Payments

Lastly, do not stop making your monthly car payment while you figure things out. Missed payments on your auto loan will have a negative impact on your credit report. Just one missed payment can affect your credit score for up to seven years! 

8 Tips To Avoid an Upside-Down Car Loan

Save yourself a world of hassle by avoiding getting into an upside-down car loan. Below are eight tips you can utilize to avoid ending up with negative equity on your vehicle. 

  1. Finance a Car That Is Within Your Budget — Take a look at your yearly budget and existing expenses to determine how much money you have to spend on a car. You may also lease a car with no credit instead of outright purchasing one to save money on your monthly payment. 
  2. Say No To Unnecessary Add-ons — Don’t let a slick salesman talk you into purchasing add-ons you don’t really want or need. Before you agree to any add-ons, think about it and ask yourself if they are worth the extra money. 
  3. Pay Fees Upfront — Car dealerships often include extra loan fees in an initial contract. Instead of letting these fees sit and rack up interest charges on your loan, pay them right away so they can’t hold you back! 
  4. Get a Lower Interest Rate — The lower your interest rate, the less money you will have to pay in addition to your base car loan principal. Negotiate with your lender to get the lowest interest rates possible.  
  5. Don’t Choose the Longest Repayment Term — Instead of going with the longest terms possible, first, decide what you want your monthly payment to be. Then, find loan terms that will result in your desired monthly payment. 
  6. Work on Improving Your Credit Score — If your FICO score has significantly improved from when you first started your car loan, you may be able to refinance and get a different loan deal with better terms and rates.
  7. Make a Higher Payment — Save even more money on your loan by paying a higher down payment. The more money you contribute to your car loan balance upfront, the less funding there is to charge interest on. 
  8. Pay More Than the Minimum — You may also consider making higher monthly payments or extra payments throughout the month on your car loan. Paying more than your minimum helps you reduce interest payments. 

FAQs About Upside Down Loans

What happens to the negative equity if I want to trade in my car?

If you’re considering trading in your vehicle, it’s important to know that negative equity doesn’t just disappear. The remaining loan balance—what you owe versus the value of your car—will likely be rolled into your new loan. This means you’ll be starting your new car loan with a balance that already exceeds your new car’s value, so consider if this move will save money in the long run.

How can I pay off the loan faster to avoid or mitigate negative equity?

Great question! Making extra payments can significantly reduce your loan balance and the duration of your loan. By doing this, you might prevent your car’s value from dropping below what you owe. Just ensure there’s no prepayment penalty in your loan agreement.

What is gap insurance and how can it help car owners with an underwater loan?

Gap insurance is a smart option for many car owners. If your car is totaled or stolen, gap insurance covers the difference between the current value of your car and the amount you still owe on your loan. This is especially valuable if you have an underwater car loan.

Does making a larger down payment help avoid negative equity?

Absolutely! A substantial down payment reduces the amount you need to borrow, giving you a head start in the race against depreciation. It’s one of the most effective strategies car owners can use to prevent ending up in a stressful financial situation.

Do I need to pay taxes on an upside-down car loan if I sell my car for less than what I owe?

Typically, if you sell your car for less than what you owe, the remaining loan amount you need to pay off doesn’t count as income, so you won’t need to pay taxes on it. However, laws can vary by location, so it’s always wise to consult with a tax professional or your lender.

What are the risks if I just stop making payments on my underwater car loan?

Stopping payments on your loan can have serious consequences, including damage to your credit score, repossession of your vehicle, and potential legal action from your lender to recover the debt. It’s always best to communicate with your lender if you’re facing financial difficulties—they may offer solutions to assist you.

CreditNinja: What You Should Know About an Upside-Down Car Loan

Having negative equity in your vehicle isn’t an ideal situation, but there are steps you can take to rectify the situation quickly. With options like refinancing to get a new loan, debt consolidation, and vehicle sales, people can free themselves of upside down car loans. 

Check out the CreditNinja blog for more free financial resources on online loans, credit card debt, and other personal finance topics.  

References:

  1. Americans Are Severely Underwater on Their Car Loans | Jalopnik
  2. Upside-Down Car Loan: How You Can Improve The Situation | Money Fit
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