Upside Down Car Loans

There are many things that can cause a car owner to owe more on a car than it’s worth. Common reasons include: bad sale terms at the time of purchase, loans that don’t pay down the principal fast enough, and sudden repair expenses that the owner must pay out of pocket. A negative equity situation can cause big financial problems if your car is stolen, gets totaled, or needs repairs that your insurance and warranty won’t cover. Thankfully, if you are upside down on a car loan, there are strategies you can use to turn right side up or to get out of the loan completely.

What Is an Upside Down Car Loan?

When someone owes more on their car than the car is worth, this is called being upside down or underwater on an auto loan. It is also called having negative equity. Being upside down usually isn’t a major problem by itself, other than the fact that it complicates a borrower’s ability to sell their vehicle. But there are a few situations wherein being upside down on an auto loan can become a big issue and lead to serious financial consequences. 

If your car is stolen or is totaled in an accident, your insurance company will only pay up to the current value of the car – not any amount of the loan above the car’s value. This means that you’ll still be financially responsible for the “gap” between the loan’s balance and the car’s value. If you don’t pay that amount of money, your lender can get a court judgment against you that may lead to garnishment of your wages or a levy of your bank account. Gap insurance may cover this difference so you aren’t on the hook for a loan on a car you don’t have anymore, but gap insurance is typically only available for newer cars for a limited period of time after purchase.

You can also run into trouble with an upside-down loan if you suddenly need car repairs that aren’t covered by your insurance or your vehicle’s warranty. If you can’t pay for the repairs out of pocket, you may need to figure out a way to sell the damaged vehicle and cover the remaining balance on your loan.

Why Do Loans Flip Upside Down?

Cars lose their value so quickly after purchase, especially during the first year of ownership. Because of this devaluation process, there are many circumstances that can lead to upside down auto loans.

You can become upside down on a new car loan right after you purchase the vehicle. For example, if you buy an overpriced vehicle, your new car’s value may already be quite close to your loan’s balance at the time of purchase. The same is true if your down payment isn’t large enough. To avoid these situations, you should look for a car that is a good value and is priced low enough for you to make a significant down payment as compared to the remainder of the loan balance. You should also avoid rolling over your negative equity into a loan for a new car, which can render you immediately underwater on the new vehicle.

Your loan can also flip upside down gradually if your car loan payments don’t pay down your principal balance faster than your car loses its value. For example, the high monthly payments on an auto loan with a high interest rate will make it difficult to pay anything extra towards principal during the loan term. On the other hand, the low monthly payments on a long-term (more than five years) loan won’t reduce your principal quickly unless you make extra payments because the payments on these loans are spread out over a longer period of time.

Finally, your loan can flip upside down suddenly if an accident or major repair issue significantly decreases the value of your car. If your insurance or car warranty won’t cover the cost to repair the damages, and you can’t cover the cost out of pocket, your vehicle may quickly become worth much less than it was worth when you bought it.

How To Calculate Negative Equity

The first step involved in figuring out whether your loan is upside down is finding out what your car loan’s payoff is. This amount is not the same as the current loan balance on your monthly loan statements. A loan’s payoff amount includes the interest that accumulates on a loan between the statement date and the date you intend to pay it off, as well as any fees allowed by the loan documents. You can probably get an informal payoff figure from your lender by phone, but you’ll need to get a payoff quote in writing when and if you’re ready to pay off the remainder of your balance.

The second step in determining your equity is to find out the current value of your vehicle. You can go to a car dealership to do this, or you can enter information about your car into a reputable online car valuation tool like Kelley Blue Book. Once you have this number, you’ll need to subtract your loan’s payoff amount from your car’s current value. If the result is a positive number, you have positive equity. If the result is a negative number, you have negative equity.

How To Resolve an Upside-Down Car Loan

There are strategies you can use to flip an upside down car loan “right side up.” Which approach will suit your circumstances best depends on your financial situation, how quickly you want to pay off the loan, and whether you want to keep your current car. If you want to keep your car, and you already have gap insurance, you should keep that in place until your car’s value exceeds your loan’s balance. This will help you avoid the possibility of owing money on the loan if your car is stolen or totaled.

Hold On To Your Car

If you want to keep your car, you can just continue making on-time payments on your loan. The loan balance will eventually become lower than the car’s value, and you’ll own your car outright once the loan is paid off. If there’s only a small difference between your car’s value and your loan balance, repayment of the loan as you’d planned may be the simplest solution to being temporarily upside down.

Get a Short-Term Auto Loan

If you bought your car with a long-term (over five year) auto loan, your payments are stretched out over a longer period of time, and you pay less toward the loan’s principal each month than you otherwise might. This means that your long-term loan’s balance goes down slowly, which increases your risk of the loan flipping upside down. Refinancing with a shorter loan term can fix this.

If you can refinance your car with a shorter-term loan, you’ll pay down your loan faster and decrease your chances of flipping (or remaining) upside down. You’ll also pay less in total interest over the life of the loan than you would with a long-term loan.

Make Extra Payments

If you can make extra payments on your car loan, you’ll pay off the loan quicker, and you’ll build equity at a faster rate. You can do this on a regular schedule -- every month or every six months. You can also make an extra payment whenever you get a sudden influx of cash, like from tax refunds, paycheck bonuses, or other irregular payment sources.

Refinance Your Car

If interest rates have dropped or your credit score has improved since you took out your original auto loan, it may be possible to refinance your loan at a lower interest rate. If you refinance only the loan’s remaining balance and don’t take any additional money out, your monthly car payment will be lower, and you’ll pay down your car loan’s balance quicker.

Sell Your Car

If you don’t want your car anymore, you can sell it, even if your loan is upside down. You should contact your lender first to let them know your plans and make sure you understand how to get the car’s title and what to do with it after the sale. If you don’t have enough savings to cover the difference between the loan balance and the expected sale price, you should also talk to your bank or credit union about getting an unsecured loan to cover that amount after the car is sold. Even though borrowing money to get out of debt may sound like a bad idea, the new unsecured loan will be smaller than the auto loan and much easier to pay off.

Once you’ve advised your lender and you’ve decided how you’re going to pay off the car loan after the sale, you’ll need to figure out the value of your car and sell it for as high a price as possible. You can use a reputable online valuation tool like Kelley Blue Book to price your vehicle, and you can use either print ads or online selling sites to market your car. After your car is sold, use the sale proceeds to pay off as much of the loan as possible, and then use either your savings or a new unsecured loan to cover the remainder of your loan balance.

Trade-In Your Car

If you go to a car dealer to trade in your old car, the dealer may offer to wrap the negative equity amount of your existing loan into a loan on a new car. This may sound like a tempting solution, but it will most likely worsen your total financial position. If you trade in a vehicle, you’ll typically get less money than you would in a sale to a private party, so you’ll stand a good chance of being already underwater on your new vehicle as soon as you drive it off the lot. Even worse, the practice of rolling over negative equity can become a repeat pattern wherein you’re always upside down on your next car.

If you find yourself in a situation where rolling over your negative equity at a dealership is your only viable option, refinancing your loan through a bank may be possible later on. Most banks won’t finance a car over 100% of its value, but once your loan amount is under the car’s value, it may be possible to get refinancing with standard terms.

Bankruptcy

If you are already in a situation where an upside-down car loan has caused significant problems in your life (such as damage to your credit), a deficiency judgment against you, or garnishments, you may want to consider filing for bankruptcy. Depending on your situation, bankruptcy can help you pay less on a car you want to keep, or it can discharge you from personal responsibility on a defaulted auto loan.

Let's Summarize...

When you owe more on your car than it’s worth, this is called being upside down, underwater, or having negative equity. If your car gets stolen, is totaled, or needs repairs that aren’t covered by your insurance or warranty, being upside down on a car loan can cause big financial problems. Unfortunately, owners can become upside down in many ways because cars lose their value so quickly through depreciation. 

There are strategies available if you want to get out of an upside-down car loan and keep your car, including refinancing, making extra payments, and simply waiting it out. It may be challenging to sell an underwater car, but you can reduce the potential negative effects of this approach with some advance planning.