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How to Get Out of an Upside-Down Car Loan

US News & World Report - Cars logo US News & World Report - Cars 11/15/2018 John M. Vincent

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Owing more money on your car than it is worth is a horrible problem to have if something terrible happens – like the car getting totaled or stolen – that forces you to pay off the entire loan. Tackle the problem being upside down on a car loan early, though, and you can come out with your credit and financial future unscathed. 

Research

We’ll help you figure out how to get out of an upside-down car loan by covering the following:

  • What Is an Upside-Down Auto Loan?
  • How You Can Get Upside Down or Underwater
  • Determining How Much Negative Equity You Have
  • Exploring Different Strategies to Get Above Water
    • Paying Your Loan Until You Have Positive Equity
    • Selling Your Car
    • Refinancing Your Loan
    • Trading Your Car In
    • Buy a Car With a Huge Rebate
    • Avoid Risky Methods of Getting Cash
    • Covering Yourself With Gap Insurance
  • Avoiding Negative Equity on Your Next Car

What Is an Upside-Down Car Loan?

When you owe more on a car loan than the car is worth, there are many terms used to describe the situation. The condition is most often referred to as being upside down, underwater, or having negative equity.

If your vehicle has a market value that is lower than the amount you owe on your car loan, you have negative equity. If it has a higher market value than the loan, you have positive equity. For example, if you owe $12,000 on a car that only has a resale value of $8,000, you have $4,000 in negative equity.

A car with negative equity is said to have a loan to value ratio (LTV) of greater than 100 percent. A vehicle valued at $20,000 with a $25,000 loan amount would have an LTV of 125 percent.

Why Is Negative Equity a Problem?

You might wonder what the big deal is. Your payments have all been on time, and you haven’t gotten a phone call from your lender telling you that there is a problem. That’s the sneaky thing about being underwater on a car loan: There’s no problem until it is a big problem.

Negative equity matters the most when you unexpectedly need to pay off the entire balance of your car financing, and you suddenly realize that the car is not worth enough money to cover the balance of the loan. If your car gets totaled or stolen, normal car insurance will only pay you the current market value of the vehicle, not the car loan balance. That could leave you owing your lender thousands for a vehicle you don't have anymore. The fact that the loan's collateral no longer exists does not excuse you from your obligation to pay back the financing.

Here’s a different scenario. We’ll say you bought that hot sports car in your single days by taking out a seven-year auto loan. Now, you’ve owned the car for a few years, but you need something more practical for your growing family. If you are upside down on your current auto loan, you’ll not only have to pay off the negative equity to the lender, but you won’t have any cash to put toward a down payment on a new car.

If you tragically suffer a medical issue or lose your job, it can be impossible to make your monthly payments. You also might not be able to get enough money out of selling the car to pay off the loan. With this scenario, you will not only be left without your car, but your credit score can be trashed for years if you can’t find a way to pay off the negative equity balance.

How Can You Get Underwater on Your Auto Loan?

There are many ways that you can get underwater on a car loan. Some are easily avoidable, while some are unexpected.

Your Car Depreciated Faster Than Expected

Sometimes you can do everything right when purchasing and financing a car and you’ll still find yourself underwater. Some vehicles will depreciate faster than expected, outpacing your ability to pay back the loan and maintain positive equity.

Market conditions can change, leaving some cars with lower values than expected. If there is a surplus of similar vehicles to yours on the local market or there's a new model out that comes with more equipment or better performance, your car won't be worth as much.

The Down Payment Wasn’t Big Enough

Vehicles typically face their greatest depreciation in the first year of ownership. Many experts cite a 20 percent drop in value the moment you drive it off the dealership lot. If you didn’t make at least a 20 percent down payment, your car will instantly be underwater.

Making a substantial down payment, having a trade-in with a high value, and getting a large cash back offer from an automaker are all ways to keep you ahead of the depreciation curve and in positive-equity territory.

A Car Loan That Is Too Long

As new car prices have steadily climbed, the length of car loans that lenders offer have been getting longer and longer. Although you’ll have a lower monthly payment with a longer loan, there is more time for interest to accrue, increasing the overall loan cost of the loan. Not long ago, the average new-car loan had a four-year term. In the second quarter of 2018, the average length of a new-car loan was 68.8 months, while the average used car loan term was 64.3 months, according to Experian. Almost a third of new-car loans exceed six years, according to Experian’s research. The longer the auto loan, in most cases, the higher the interest rate that the lender will charge. That’s because longer loans come with more risk that the loan will not be repaid. While you might be able to get a great rate on a five-year loan, getting one on longer-term financing is difficult. 

In the early years of an auto loan, much of each monthly payment goes to paying interest and not to bringing down the loan balance. With the steep depreciation that vehicles face in the first couple years of ownership, it’s nearly impossible for the payments on a long-term auto loan to keep pace with a car’s decline in value during the early years of a loan.

Here’s an example, using our auto loan calculator to determine the monthly payment. We’ll say that you will purchased a $30,000 SUV, pay nothing as a down payment, and finance with a 4.5 percent interest rate for four years. Your monthly payments would be $684 per month. Delving deeper into the loan’s amortization schedule – something your lender can provide to you – we can see that about $572 goes to pay down the loan balance and $113 pays interest in the first month of the loan. Each month the portion of the payment that goes toward principal rises by a few dollars, with $596 going to principal at the end of the first year of the loan.

If we assume that the SUV loses 20 percent of its value ($6,000) in year one of ownership, and the amortization table shows that the loan balance is $23,593, you would have positive equity of $7 after a year. That’s not much, but you’re still in positive territory.

Stretch that same loan out to six years, and you would have to pay a higher interest rate. We’ll say 5.75 percent for the sake of this example. Your monthly payments drop dramatically to $494 per month, but in the first month of the loan, you only pay $350 to principal. The other $144 goes to interest. The amortization table for this loan shows that you’ll owe $26,058 at the end of the first year, on an SUV that is only worth $24,000.

By taking the longer loan, you’ll be more than $2,000 underwater after a year. Pairing a long auto loan with a low down payment can be a recipe for financial disaster.

The Interest Rate Is High

Interest rates are slowly climbing, even for buyers with excellent credit. If you have bad credit, you can find yourself paying several times the rate borrowers with prime credit are charged. Most of the payments made at the beginning of a high-interest-rate loan go toward interest, making it extremely difficult to keep up with a car’s depreciation.

While it might be tempting to seek out an extended loan term to minimize the size of monthly payments, this example shows how quickly you can get into severe financial jeopardy with a long-term loan. While the interest rate in this example would not be uncommon for a subprime borrower, let’s you had a higher interest rate of 10.99 percent for the six-year loan. Your monthly payment would jump to $571 per month. 

Even with the higher monthly payment, the amortization schedule for this loan shows that you’ll owe $26,589 at the end of the first year. You’ll be nearly $2,600 underwater on the loan.

Rolling the Balance of an Old Car Loan Into a New Car Loan

You have probably seen the dealer ads that promise to pay off your existing car loan when you buy a car from that dealer. What is not clear is that the money they use to pay off your current car loan doesn’t just come out of thin air. Instead, they simply add the balance of your old loan to your new loan.

While it seems convenient, it's a horrible way to buy a new car and puts you at serious risk of financial pain if something terrible happens in your life.

Let’s say you still owe $6,000 on your current sports car, which is only valued at $4,000. The car dealership generously offers to pay off the $6,000 loan, give you $4,000 for the trade-in, and to roll the $2,000 difference into a new loan on a $30,000 compact SUV. Before you even leave the dealership, you’ll have negative equity of $2,000. If you don’t make a substantial down payment or take out a long-term auto loan, that number will only get bigger after the first couple of years of the loan.

Financing Fees and Add-ons When You Buy

Financing anything that does not add value to the resale price of the car raises your loan-to-value ratio and puts you at higher risk of being upside down on your financing. Though they may cost you hundreds or thousands of dollars, costly add-ons such as extended warranties don’t add significant resale value to your vehicle.

A better plan is to pay cash for any add-ons when you purchase the vehicle and comparison shop for the best price both from the dealership and from third-party vendors. You will likely face pressure from dealership financing managers to decide on the spot whether to buy add-on products so they can include them in the financing package they offer you – don’t buckle under the pressure.

Determining How Much Negative Equity You Have

Figuring out how much positive or negative equity you have is easy. You simply subtract your auto loan balance from the current value of the car. A call to your lender can provide you with the current loan payoff balance, or you can likely find it by accessing your loan account online.

Your vehicle’s current price can be found using the What’s My Car Worth Tool on our used car page. Clicking on the “Edit Vehicle Details” text will allow you to refine the value based on your car’s equipment, location, and mileage. The more details you provide, the better estimate of its price you will get. 

Here’s an example of the math: You have a vehicle that is valued at $12,000 with a loan of $15,000. Subtract $15,000 from $12,000 and the result is negative $3,000. In other words, you are upside down on your car $3,000. If you’re upside down just a little, and you have money in the bank that could take care of the difference if you needed it to, there’s really nothing to worry about. On the other hand, if the difference between your car’s value and your loan is great, you’ll want to look at some options for lowering or eliminating the risk.

Exploring Different Strategies to Get Above Water

When it comes to getting out of an upside-down car loan, it’s important to not dig the hole any deeper. Missing payments will cause more interest and fees to be added to the loan, plus risk the chances of loan default and repossession. In many states, when a repossession occurs, lenders can still seek the difference between the loan balance and the vehicle's value, as well as the costs involved in repossessing the car.

Getting your head above water – or at least minimizing the financial damage from being underwater – is possible, though you need to be disciplined with your money to take advantage of these strategies.

Paying Your Loan Until You Have Positive Equity

By far, the best way to get out from underwater on an upside-down auto loan is to keep making your car payments, which brings down the balance of the loan. If your lender allows it and there are no prepayment penalties in your loan contract, you can overpay your monthly payments and have the additional cash applied to principal, increasing your equity as quickly as possible. 

Staying on your repayment schedule has other benefits. With each on-time payment, you get rid of a bit more debt, and the lender will report both the declining loan amount and the fact that you are making on-time car payments to credit reporting agencies. That will boost your credit reports and your credit score.

There is a bit of risk with this strategy. If you get in an accident that totals the car or it is stolen while you still have a negative equity car loan, you’ll still be responsible for paying the balance of the loan. That’s fine if you can afford it, but it’s a problem if you don’t have that kind of cash on hand.

Selling Your Car

A great way to get out of an upside-down car loan is to sell your car and pay off the loan balance – but you’ll want to get the highest possible sales price when you do so. The best way to do that is to sell it yourself. Our article on How to Sell Your Car will walk you through the details, but here’s a summary of the steps you’ll need to take:

Gather Your Documents

A vehicle with a well-documented history is more valuable than one with a sketchy past. Gather and organize all of your service records, plus any proof that you have had collision damage properly repaired. Most buyers will get a vehicle history report before they consider your vehicle, and you'll have to be prepared to back up the information in that report with your records.

Since you have a loan on the vehicle, your car’s title will be held by your lender. It’s a good idea to talk to them so that you know the procedure to pay off your loan and get the title to the vehicle’s new owner after you sell it.

Prepare Your Car For Sale

You’ll want to get your vehicle’s appearance in tip-top shape if you're going to get top dollar from a buyer. A good wash, a wax job to get the paint as shiny as possible, and a thorough interior cleaning might take a weekend, but that work will pay off by making a good first impression with potential customers. 

If there are any minor repairs or maintenance that you can perform without a lot of expense, you should do them. Don't spend too much money on refurbishing the vehicle, however, as you likely won’t get it back from the sale.

Set the Right Price

While you might want to set the price of your car right at the amount you owe on it, you probably will have to accept a little less. Keep in mind, the whole concept of being upside down is that the market value of the car is lower than the balance of your auto loan.

The art of setting the right car price requires you to make it high enough that you have some negotiating room without being so high that it scares away potential buyers. The higher the price, compared to similar models available in your market, the longer it will take to sell. If you’re lower, you’ll likely be able to sell it quickly, but you won’t get as much money to put toward paying off your auto loan.

Online sales tools, including the What’s My Car Worth? tool on our used car page, will give you a ballpark of what you should price your used car in. You can refine that number by looking at used car listings in your area to see what similar cars are selling for. Many car owners believe that their vehicles are worth more than others, put it’s important to any emotional attachment aside and look at your car the way a buyer would. 

If your car's price differs substantially from others in your market, you'll need to explain why in the ad. Saying "new tires less than 1,000 miles ago" can explain a high price, while "needs brakes" can justify a price that's slightly below the market average.

Advertise in the Right Places

You want to get the best price out of the car sale without spending a lot of money to do so. In the day of Craigslist.com and other free online advertising sites, you can pass on newspapers and other fee-based used car sites and still reach the customers you need to.

A successful car advertisement should include a detailed description, including the vehicle’s mileage, standard features, optional equipment, and any extras that you’re including in the sale (such as a roof rack or custom wheels.) Include photos of your car from every angle and show plenty of details. Be sure that your home address and the car's license plate are hidden in the pictures. State the that the car is being sold “as-is” with no warranty other than the balance of the manufacturer’s coverage, if any. Using words such as “firm” or “best offer” can telegraph your pricing flexibility to buyers.

Before you put a for sale sign in the window and park it on the street, check to make sure it is legal to do so in your area. The cost of a ticket won’t help you to the goal of paying off your car financing.

Show, Allow Test Drives, and Inspections

The process of showing your car can be a little scary for some sellers. Meet any buyers in public settings away from your own home. Some police agencies have set up safe exchange areas with video surveillance, and they’re a great place to meet potential buyers.

Buyers will judge you as much as they judge the car, so stay professional and confident, and you're less likely to be seen as a pushover when the time for price negotiation comes.

Any smart buyer will want to take a test drive. You'll want to accompany them as safely as possible. Before you start the drive, text a photo of the potential buyer’s driver’s license to a friend. If you feel unsafe or outnumbered, schedule another time for the drive when you can have a friend along. Don’t allow the potential buyer to drive in a risky manner. If they wreck the car, you’ll only get as much of a market value as the insurance company wants to pay you – and the whole point of selling it yourself is to get the most money you can.

Many buyers will also want a pre-purchase inspection, and you'll need to make your vehicle available for that to happen. Refusing to allow a buyer to get an inspection will cause most to walk away from any potential purchase.

Negotiate a Fair Sales Price

The key to successfully negotiating a fair sales price is to be polite and confident in your offers. You should be able to back them up with facts about why the car is worth the amount you are asking. Be prepared for the buyer to come in with a low-ball offer to start. Not only are they trying to see how firm you are, but they're also trying to shake your confidence in the sales price. Counter the first offer with a price near your asking price. Remember, once you throw a price out, you can't go any higher. Once a buyer offers an amount, they can't go any lower.

Be prepared to walk away from a potential buyer if their offer is not acceptable. If you keep getting low offers and negotiations that won’t come up to the price you want, however, you might have to lower your expectations. 

Complete the Paperwork and Get Paid

You don't ever want to accept payment for a car by personal check or money order. The best way to make sure that you don't get ripped off is to meet the buyer at their bank and accept a cashier's check or cash there. If you’re not able to get the check straight from the bank, be sure to check the authenticity of any cashier’s check with the issuing bank before you sign over the car’s title.

Since you are not at a car dealership, you’ll need to work with the buyer to ensure that all necessary DMV paperwork is completed. There are many bill of sale forms available online. Just make sure that whatever one you choose states that the vehicle is sold as-is with no warranty.

After the sale is complete, send the funds to pay off your car loan to your lender and contact your car insurance agent and cancel the coverage on the car.

Refinancing Your Loan

Another way to get rid of an upside-down loan is to refinance the vehicle with a new auto loan. This is an excellent choice if you can come up with some cash to bring your LTV ratio close to 100 percent. It can be hard to find a lender willing to make a loan with a large amount of negative equity, though. Focusing your search on credit unions and community banks will give you the best chance of talking to a person about your loan. That way, you won’t be rejected by an automated loan underwriting system.

If you had poor credit when you took out the loan, you likely are paying a higher-than-average interest rate, where a higher percentage of each car payment goes to paying interest rather than principal. By paying as agreed for the first year or so of the loan, your credit score may have improved enough to qualify you for a lower interest rate, giving you a faster route to having positive equity on the loan.

Closely compare any refinancing offers to your current loan deal. With a negative-equity car loan, you'll typically have to pay a higher interest rate due to the higher risk the lender is taking on. That's because car loans are secured by collateral. For auto loans, your car is the collateral. To the lender, any negative equity is essentially an unsecured loan.

Only refinance if you are bringing your interest rate down, shortening the length with the new loan, or both. You only want a new loan with a higher monthly payment if more of each payment is going toward increasing your equity.

Read our article on auto loan refinancing to learn more about the process.

Trading Your Car In

Another way to get out from under a bad car loan is to trade the vehicle in at a dealership. Unfortunately, it is not a good route to go, as the wholesale trade-in value you’re likely to get from a car dealer won’t give you enough money to cover the amount you are upside down on your current loan.

If you find a dealer that is excited about taking your underwater trade-in, and they promise to pay off your old car loan, you should run away as fast as you can. Although it’s true that they'll pay off your existing loan, they will add the amount of negative equity to the loan on your new car, and you'll start that loan even further underwater than you were before. That is one of the worst possible ways you can buy a car.

Remember the first rule of getting out of a hole: Stop digging deeper.

Buy a Car With a Huge Rebate

When you explore our new car deals page, you'll see some vehicles offered with massive cash rebates. Trading your car and buying a new one with a substantial cash rebate can get you back into positive territory (at least on paper), but only if you do it right.

Let’s say that you have a $12,000 loan on your current car, which is worth $10,000. You have found a new $30,000 car with a $6,000 rebate, making its net price $24,000. Buy the new car and trade in your old one, and the dealer will pay off the $12,000 loan on your current vehicle and add the $2,000 in negative equity to the new loan, making it $26,000. On day one of the loan, you'll have $4,000 in positive equity on your new car. Of course, the new vehicle will rapidly depreciate during your first year of ownership, so you'll want to have a relatively short-term car loan with the lowest interest rate possible. That combination will allow you to pay down principal quickly and stay above water on the loan.

If you were to do the same transaction on a vehicle without a large rebate, you would be underwater immediately on the new car loan.

Avoid Risky Methods of Getting Cash

There are a couple of riskier methods of getting out of an upside-down car loan. The upside is that if everything in your life goes perfectly, they’ll both work out fine. The downside is that one puts you at risk of high interest rate debt, while the other places your home at risk.

Credit Cards

Some websites suggest looking for offers on credit cards with a zero percent introductory periods and using them to pay down your negative equity. You then pay off the credit card before the introductory period is over and, since you have positive equity, refinance your car at a lower interest rate or with a shorter term.

Here’s the rub. Most zero percent interest rate cards only offer the zero percent on purchases, not the cash advances you would use to pay off the negative equity. Since most credit card interest rates are pretty high, it’s easy to put yourself in another debt trap. Second, even if you find credit cards that won’t charge you any interest on the money you use to pay off your car loan’s negative equity, the interest rate will jump to a high rate once the intro period is over. If something happens in your life that prevents you from paying the credit cards off on time, you'll be saddled with an expensive new obligation. 

Home Equity Loans

Home equity loans and home equity lines of credit come with low-interest rates because they are secured by your home. They're an easy way to get cash, though, so some websites suggest using them to get out of underwater car loans. The problem is you are essentially taking car debt and turning it into a lien against your home. That rollover is an idea that you should try to avoid at all costs.

If everything goes great in your life, and you are able to make both your car loan payments and payments on the home equity loans, everything will be fine. If something happens, however, you’ll be at risk for both a car repossession and a home foreclosure.

Covering Yourself With Gap Insurance

If you think that you have an auto loan that might go underwater, you should think about purchasing gap insurance around the time you buy your car. Though you might be able to get it later, it’s more challenging to do so.

Gap, or guaranteed asset protection, covers the difference between the loan balance and the market value of your auto in the event it is totaled or stolen. The percentage of your car’s value that is covered differs from policy to policy, so if there’s a huge gulf between your car’s loan balance and its resale value, you may still owe some money.

It does not help with any balance that is left after a loan default, voluntary repossession, or forced repossession of your vehicle. A lender can still seek to collect that amount.

Most car dealers will offer gap coverage during the loan signing process, but you should compare their offer with others before you sign up. Most auto insurers, banks, and credit unions also offer gap products, and prices and coverage will vary greatly and depend on where you get your policy. 

Avoiding Negative Equity on Your Next Car

Once you have been upside down on a car loan, it’s hard to escape the debt trap. The most important thing you can do to protect your financial security is avoid the temptation of rolling the negative equity into the loan on a new vehicle (unless there’s a massive cash rebate).

Avoiding extended terms on your car loan can also keep your financing above water. If you need a car loan that’s longer than five years, many experts agree, you can’t afford the car. Perhaps look at less expensive options or consider a certified pre-owned vehicle instead of a new one. Though it will cost you more money out-of-pocket in the long run, you might consider leasing as a way to keep your car payments affordable, while having a set of wheels that fits your needs.

Working to improve and maintain your credit score can also help to keep your interest rates low and qualify you for the best new car incentives and lease deals. You're entitled to see each of your credit reports from the three major credit reporting agencies once per year. Check them for incorrect information and work to improve any weaknesses so that you can avoid being forced into a bad car loan with terms that drive you into negative-equity territory.

More Shopping Tools From U.S. News & World Report

When it comes time to buy or lease a new car, the experts at U.S. News Best Cars offer an array of resources to help you find the vehicle that fits your needs, avoid overpaying for it at the dealership, and get the proper car insurance.

Our new car rankings and reviews are based on the consensus opinion of the country’s premier automotive journalists, plus quantitative data on safety and projected reliability. For used cars rankings and reviews, we add total cost of ownership to the mix, so you can estimate the total cost of a vehicle as the years march on.

We’ll help you find an affordable price on your next ride with our research into the best new car deals, affordable lease deals, and used car financing offers. The U.S. News Best Price Program links consumers with local dealers offering guaranteed savings. On average, buyers save more than $3,000 when they use the program. You can estimate how much are you can afford and determine your monthly payments using our car loan calculator.

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