Owing more on a car loan than the vehicle is worth is a common problem for today’s buyers. With high-priced vehicles, small down payments, and five-year or longer loans, having negative equity can be hard to avoid.
The auto industry has several terms for having a bigger loan balance than the resale value of a vehicle. The technical term is having negative equity, but it also is called being “upside-down” or “underwater” on your loan. Being underwater isn’t typically a problem unless the car is stolen, declared a total loss by an insurance company, or you want to replace it with another vehicle.
You want to check the value of your car and your loan balance long before your car shopping odyssey begins. One of the last places you want to learn you have negative equity is in a car dealership’s financing office. It can prevent you from getting a good trade-in value to pay off your existing loan.
In this upside-down car loan guide, we’ll explore the following topics:
- What Does the Term Upside-Down Auto Loan Mean?
- Why You Don’t Want to Have an Upside-Down Car Loan
- Determining How Much Negative Equity You Have
- How You Can Get Upside Down on Your Auto Loan
- Protecting Yourself if Your Car Loan is Underwater
- Different Strategies to Get Above Water
- Avoiding Negative Equity on Your Next Car
An upside-down car loan is one where you owe more on your auto loan than the car is currently worth. For example, if you have a car loan with a $20,000 balance on a car that only has a market value of $17,000, you have $3,000 negative equity. To say it another way, you’re $3,000 underwater on your auto loan.
On the other hand, if you have a vehicle that’s valued at $17,000 and the loan balance (also called payoff amount) is $15,000, you have $2,000 in positive equity, so the car is not underwater.
In technical terms, a car that is underwater has a loan-to-value (LTV) ratio that is greater than 100%. Lenders consider the LTV ratio when making financing decisions and setting loan terms.
If you're paying the loan off as agreed, with no missed or incomplete payments, you might never know you're underwater on the loan. It's only when you try to sell the car, it is stolen, or it is declared a total loss by an insurance company that you need to begin worrying.
Let's first look at the situation where you're tired of your current car and want to replace it with a new car. If you have positive equity, you can pay off the loan with the car's selling price or trade-in value. Any positive equity you have can be used to make a down payment on your next vehicle. If, on the other hand, you have negative equity, you won’t have anything to put toward your new car’s down payment. Instead, you’ll have to figure out a way to pay off your old loan, so you can get your old car’s title and sell or trade it in. You cannot have financing on a vehicle you no longer own, as the car was the collateral used to secure the loan. In many cases, the dealer's finance officer will offer to rollover the existing loan balance into your new loan. That's a horrible financial decision, as we'll discuss a little later.
Worse still is if your upside-down car is stolen or declared a total loss after a crash. The check you receive from your insurance company won’t be enough to pay off your car loan. The amount they will pay on your collision or comprehensive policy is their opinion of the vehicle’s market value, not the balance of your loan.
Since the collateral backing the financing (your car) is gone, your lender has the option of calling the remaining balance of the loan due immediately. Just because the collateral no longer exists, you are not excused from paying back the remaining loan balance. Not only do you have to deal with the trauma of a collision or car theft, but also the stress caused by your lender’s repayment demand.
Your situation is much more precarious when you're underwater on a car loan if you become suddenly ill or lose your job. The same is true with any other life event that makes it impossible to make your monthly payments. If you have positive equity, you can simply sell the car and pay off the loan. When there's negative equity, you won't get enough money out of the vehicle to ultimately pay off the loan. The rest of the cash will have to come from your savings or another, perhaps riskier and more expensive, loan.
Figuring out whether you have positive or negative equity is easy: You simply subtract your auto loan balance from the current resale value of your used car. If the result is a positive number, that's great; you have positive equity. If the number is negative, you're upside-down on your loan. The more negative the number is, the further underwater your auto loan is.
Here's an example: You have an SUV with a loan balance of $25,000. You can use it as a trade-in and get $28,000 for it. Subtract $25,000 from $28,000, and you'll see you have $3,000 in positive equity. Now, let's say your loan balance is $32,000. Subtract $32,000 from $28,000 and you get -$4,000. That means you're $4,000 underwater on the loan.
If you can find someone willing to pay you $30,000 for the SUV and you have a $32,000 loan, you’re only $2,000 upside-down.
In other words, the amount you are underwater can be greatly affected by the amount you can get out of your car. You'll likely get the highest amount from a private-party sale, and the lowest if your lender repossesses your vehicle.
If you're just a little bit underwater, you might be able to cover the difference from your savings. If you're massively underwater, a crash, theft, or another financial issue can turn into a calamity. Underwater borrowers who can't pay off the remaining balance can see their credit rating destroyed.
Finding the market value of your car can be a bit elusive. You can go with one of the book values found on some websites, or explore our used car listings to see what similar used vehicles in your area are going for. The valuation you receive from an insurance company may be radically different, based on the sources they use for pre-owned vehicle values. Remember, the trade-in price you receive from a car dealer will likely be substantially less than if you sell it yourself to a private-party buyer.
There are several ways a borrower can find themselves upside-down on their car loan. Some, such as depreciation, are hard to control, while others require disciplined buying to avoid costly mistakes.
Your Car Depreciated Quickly
Most new cars depreciate very quickly the moment they leave the dealership. That rapid rate of depreciation continues for the first couple of years of ownership, then begins to level off as the vehicle ages. At the same time, a large percentage of the monthly payments early in a new car loan goes toward paying interest rather than principal.
That combination makes it difficult for borrowers to keep up with depreciation and gain positive equity during the early years of the loan.
Even if you bought a vehicle that is expected to hold its value well, market conditions could change. Certain circumstances may cause depreciation that's so steep, your car payments won't keep up with its declining value. If, for example, a pervasive problem crops up with the model you chose, its value will likely decline. Likewise, if a car's manufacturer dumps thousands of similar vehicles into rental car fleets, the resale value of your vehicle will suffer.
How to avoid this issue: You can escape falling behind the depreciation curve in several ways. Making a larger down payment, keeping the loan term as short as possible, and paying a little extra with each of your car payments can keep you on a better pace. Used cars depreciate at a slow rate, so their loan payments are much more likely to keep pace with any decline in value.
The Down Payment Wasn’t Big Enough
It’s common for both new and used car buyers to pick up a vehicle with no down payment and no trade-in. Doing so, especially with a new car loan, means you’ll be underwater the moment you sign the dealership paperwork. Unless it’s a collector car, vehicles depreciate. In most cases, the payments early in a typical car loan will not keep up with the rapid decline in value the vehicle suffers during its time on the road.
How to avoid this issue: Make a substantial down payment that puts you well ahead of the car’s depreciation curve. The standard was once 20%, though the price of today's new vehicles puts that number out of reach for many consumers.
By selling your old car yourself to another private party, you can frequently get more out of it than trading it in to a dealership. That extra cash can be used to increase your down payment. A substantial down payment also potentially gives you the advantage of a better loan interest rate or a shorter loan term. Both make it easier for your payments to keep pace with depreciation.
The Car Loan Is Too Long
As both new and used car prices continue to climb, consumers are borrowing money for longer and longer periods. Stretching an auto loan to six, seven, or even eight years can produce an affordable monthly payment. Unfortunately, it can also make it impossible for your payments to keep up with depreciation.
You’ll also pay much more interest over the life of the loan. We talk about why extended car loans are a poor financial decision in our story about long-term auto loans.
How to avoid this issue: You can avoid the dangers of long-term auto loans by getting the shortest loan you can afford. That can even mean buying a less expensive car than one that requires an extended car loan or buying a used car instead of a new vehicle.
A Loan Interest Rate That’s Too High
The higher the interest rate on a car loan, the more of each payment goes to paying interest, rather than principal. The difference is most acute early in a new loan; at the same time, most new cars are depreciating rapidly.
Used cars tend to have higher loan interest rates than new vehicles, making it harder to keep up with even a used car's slower depreciation.
How to avoid this issue: There are many ways to get a lower interest rate on a new or used car. The best way is to have a pre-approved auto loan offer in place before you visit the dealership. That allows you to shop around at multiple banks, credit unions, and other lenders for the best rate, rather than just accepting what the dealer offers.
The interest rate a borrower is charged is based partly on their credit score. If you take the time to understand what is in your credit report and work to improve your score, you can potentially lower your interest rate. If you have abysmal credit, you'll need to consider whether it is appropriate to buy a car at all. You may want to consider purchasing the cheapest car possible to get the best loan terms.
When borrowers make a substantial down payment or take a relatively short loan, they can qualify for a significantly lower interest rate. Borrowers with excellent credit can qualify for special financing deals that can reduce their interest to as low as zero percent.
Our guide to financing a car and getting a car loan talks about the automotive financing process in greater detail.
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Rollover of a Previous Car Loan
Ever see those car dealership ads that promise to pay off your current loan so you can get a new car? Here’s the thing – your existing loan balance doesn’t magically disappear. Instead, they rollover your existing balance into the loan for your new vehicle.
For example, we’ll say you’re $3,000 underwater on your current loan and you’re buying a subcompact SUV with a negotiated price of $25,000. Because you’re underwater, the entire value of your trade-in goes toward your existing loan, and you don't have any additional equity to make a down payment.
Instead of applying for a $25,000 loan, the dealer's finance office will work with lenders to get you a $28,000 loan. In this example, you would be $3,000 underwater on your new car before you even leave the dealership. Your LTV ratio on the new loan would be well over 100%, so you could expect to pay a higher interest rate than you would on a more sensible loan.
How to avoid this issue: Rolling the balance of a negative equity car loan into the financing of another car is one of the most dangerous car-buying mistakes you can make. If you have to do so to buy a car, you should consider it a sign that you should not be in the market for a new ride.
Simply put, never roll the negative equity from one car loan onto another loan.
Financing Fees or Costly Extras
Anything you add to your car loan that does not increase the value of the vehicle lowers your LTV ratio and increases the likelihood you will have an upside-down car loan. Most dealer add-ons, such as extended warranties, protection packages, window etching, and insurance products, don't add appreciably to the car's resale value. Even if they add some value, it won't approach the additional amount you have to finance and pay interest on.
Read our article about costly dealer add-ons to learn more about these products.
Sometimes extras find their way into the sales paperwork without your knowledge or approval. Be sure to read every sales document to ensure that the deal you agreed to is the one you're getting, without any surprises.
How to avoid this issue: Even if you decide to buy costly extras through the dealership, you should pay for them upfront, and never finance them. Financing them increases your monthly payment, costs you a significant amount in interest, and increases your chances of having negative equity.
If you have negative equity on your car loan, you should keep making your monthly payments in full – and maybe pay a little extra each month. The goal is to have your principal payments outpace the depreciation of your car and move you into positive equity territory.
During the time you have negative equity, you can protect your finances with gap coverage. Gap insurance will pay the difference between your car’s value and the amount you owe in case of a theft or a total loss. In essence, it protects both the lender’s collateral and your finances.
While a dealership may offer gap coverage, it’s a good idea to price and compare policies from other sources, including your lender and auto insurance company. You can potentially save money by purchasing the product in a bundle with the rest of your car insurance policies.
It is essential to read the policy so you understand what is – and is not – covered by that specific policy. Gap coverage will only take care of you when your vehicle is lost. It will not cover your negative equity if you decide to sell or trade your vehicle. Most will not cover any carry-over negative equity rolled into a new loan from a previous car.
Read our guide to gap insurance to learn more.
If you find yourself with negative equity, there are several ways to get out. Some won't have much of an effect on your finances, and may even raise your credit score. Others can be devastating to both your pocketbook and ability to get credit. Our article titled How to Get Out of an Upside-Down Car Loan discusses each method in greater detail.
Pay Your Loan Until You Have Positive Equity: By far, the best way to bring your auto loan above water is to make your payments until you get into positive equity territory. Adding a bit extra or making an additional payment now and then will get you on the plus side faster. If you have bad credit, this method will help to improve your credit scores, as well.
Sell Your Car to a Private Party: By selling your car to a private-party buyer, you can get the highest possible price. It takes some effort and fortitude, but it’s the sales method most likely to get you close to the amount of money you need to pay off your loan. Our guide to selling your car shows the fine points of getting the most out of your used car.
Refinance Your Loan: By refinancing your auto loan, you may be able to get a shorter loan term or qualify for a lower interest rate. Either will increase the pace you pay back principal and get you closer to positive equity. That’s especially true if your credit standing has improved since you first took out the loan.
Buy a New Car With a Huge Rebate: If you can find a new car deal with a massive cash rebate, you can potentially erase your negative equity or substantially reduce it. Plus, you get a new car.
Get a Side Job: While the idea of driving for a ride-hailing company such as Lyft or Uber may not be your definition of fun, it can make you enough cash to get you into positive equity territory. In many places, you can also deliver packages as a freelance driver for Amazon.com. Just be sure to check with your lender to ensure your current car loan does not restrict such usage.
Trade Your Car In: When you trade your car in to a car dealership, you shouldn't expect top dollar. They have the cost of reconditioning, marketing, and selling the vehicle to consider. It is a way to get rid of the vehicle, however. Of course, you'll still have to pay your lender the difference between your loan balance and the amount the dealership gives you.
Credit Cards: Some experts advise consumers to take advantage of a low- or no-interest introductory deal on a credit card and charge the amount of negative equity to the card. Then, pay back the credit card balance before the promotional period is up. The problem is, if you're not totally disciplined, you can end up with high-interest rate credit card debt on top of your monthly car payments.
Home Equity Loans: While credit card interest rates can be astronomical, interest rates on home equity loans and home equity lines of credit (HELOCs) can be very low. The difference is credit card debt is unsecured, while home equity debt is backed by your house. It’s never a good idea to back anything other than your primary mortgage or home improvements with your house. If you transfer your car loan’s negative equity to a home equity loan and fail to make your payments, you can lose your house. That’s a lousy trade-off.
Let Your Car Be Repossessed: Borrowers who are at their wits’ end and can't make their payments should consider letting the lender take the car back. A voluntary repossession, where you take the car directly to the lender, is much better than having a repossession company chase down your vehicle. Of course, you'll still be liable for the difference between what value the bank can recover and your loan balance. This method will likely wreck your credit for an extended period.
Having negative equity on a car loan can create a long-term debt trap that’s hard to escape. The best way to avoid that trap is to make smart decisions when it comes time to get a new vehicle and a new car loan.
You’ll want to choose a car that’s within your means, without the need for a long-term car loan or monthly payments that stretch your family budget to the edge. Most experts agree if you need a loan longer than five years to get the monthly payment to fit your budget, you can’t afford the vehicle. It might be a bitter pill to swallow, but you should consider a certified used car instead of a new one, or a vehicle with fewer features.
Though it might cost you more in the long run, leasing a car could get you lower monthly payments. Our guide to buying versus leasing walks you through the pros and cons of each.
Improving and maintaining a solid credit score has several benefits. The higher your credit score, the better the interest rates and loan terms you will receive. A prime or above credit score can also score you generous car deals and lease incentives from automakers.
More Shopping Tools From U.S. News & World Report
Whether you’re looking for an inexpensive used car or trading up to something new, the Autos team at U.S. News & World Report offers the resources to help you find the right vehicle at the right price. Our new car rankings and reviews and used car rankings and reviews are designed with consumers in mind. We know the questions you’re asking and strive to answer them in an unbiased manner.
A great way to get an affordable price on a car is by taking advantage of incentives from automakers. Our new car deals page tracks the best cash back and financing offers in the marketplace. Lease customers can find offers with low monthly payments and little due at signing on our lease deals page. Shoppers considering certified pre-owned models should explore our used car deals page to find special financing offers.
The U.S. News Best Price Program links buyers and lease customers with dealers offering pre-negotiated pricing. On average, buyers save more than $3,000 when they use the program.
A critical part of car ownership is having the right insurance. Our car insurance hub helps you identify the coverage you need, the least expensive insurance company in your state, and discounts that can save you money.