When the amount you currently owe on your car loan is more than your car's value, it means you have negative equity, which is commonly called an upside-down car loan. Your options are drastically reduced in this situation: if you want to sell or trade in the vehicle, you will have to come up with extra cash to pay off the rest of the loan. Even if you intend to keep the car, you are still at risk for owing your lender money if the vehicle is stolen or totaled in an accident while you have an upside-down car loan.
One of the worst things people with an upside car loan can do is dig yourself into a deeper financial hole, says Bankrate.com Chief Financial Advisor Greg McBride. "Even somebody with all the best intentions, through no fault of their own, can end up in this situation," he says. "And the situation perpetuates itself when you're getting a new car … handcuffing you financially."
You can break the cycle by understanding why your car loan is upside down, taking steps to fix the problem and safeguarding yourself from making these common mistakes on your next loan. We explain below five of the top reasons why your car loan is upside down.
Your Down Payment Was Too Low
A down payment that was too small (or absent altogether) can quickly cause the balance of your car loan to soar above your car's actual value. You are especially at risk for this if you buy a new car with little or no money down. That's because the value of a new car drops by about 20 percent the first year you own it -- much faster than the average 13.1 percent annual decrease for a used car. A healthy down payment can help keep your loan balance more in line with the worth of your car. Used car buyers also have to make sure they put down enough money. Otherwise, the fees and taxes that aren't covered by your down payment will be added directly to your loan.
Your Interest Rate is Too High
Your car loan may also be the culprit. All vehicles depreciate in value, which means they are worth less each year. Typically, you can't sell your car for the same amount you bought it for because of this steady price drop. It's important to have a car loan that you can pay off fast enough to keep the balance of your loan below the amount you can sell your car for. If your interest rate is too high or your car payments are too low, it will take you longer to pay down your loan. A car loan like this can lead to the loan becoming upside down even when you paid a down payment and make all your loan payments on time.
You Need More Savings
"The lack of sufficient savings is the big problem," says McBride. When you have money set aside, more options are available to you when you purchase a car. You can decide if it is better to use your cash for a larger down payment, or if you qualify for one of the low interest rates currently available, you can hold the money in savings in case something happens. "One thing that people are not aware of is that if your car gets totaled in an accident or stolen, you can end up in a bad situation through no fault of your own," cautions McBride. "You buy a car, you make little or no down payment, and six months later the car gets totaled in an accident. You're upside down. And you'll be on the hook for the balance. But if you make a down payment or you have savings, you insure against these remote possibilities."
You Were Already Upside Down
Your upside-down car loan may have nothing to do at all with your current car, but may have carried over from your last car. Many dealers offer what's called a roll-over loan: after you trade in your car, if the loan isn't paid off in full from the trade-in amount, the balance gets applied to your new loan. "When people trade in an upside-down vehicle, they only compound the problem because they roll that negative equity into the purchase of the next car. So they’re only further upside down," McBride says. He adds that frequently trading in your vehicle for another increases the chance of getting upside down or makes the problem even worse if you were already upside down.
You Aren't Keeping Your Vehicles Long Enough
Getting rid of your car too soon is one of the top reasons people wind up with an upside-down car loan, says McBride. "The car depreciates fastest early in its life. The loan balance declines the slowest early in its life," he explains. "Those first few years, you're on the wrong side of the equation. The longer you keep the vehicle, you get the opportunity for those lines to cross in your favor to the point where the balance is now less than the current value of the vehicle."
If you have an upside-down car loan, McBride recommends hanging on to your car to break the cycle of being upside down with each successive car loan. "Keep the car. Ideally until the loan is paid off, so you’ve got some time to bank some monthly savings. But at the very least until there is some equity in the vehicle." If you still own your car after you finish paying it off, McBride suggests you put the same amount of money you were spending on your car payment each month into a savings account so "when you go to buy the next car, you've got some equity in your trade in and you've got money for a down payment."
Now that you can pinpoint the circumstances that led to your upside-down car loan, you can hopefully prevent the problem from carrying over to your next car loan. Find out how to get out of an upside-down car loan here. And keep up with our latest tips on car loans and car shopping by following us on Twitter and Facebook.