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9 ways to avoid, correct upside down car loans

Long-term auto financing is gaining traction with consumers hit hard by rising interest rates and out-of-control gas prices. More than half of new-car loans were for five, six, even seven years last year, according to the Consumer Bankers Association. That was up from 22 percent at the start of the decade.

At first glance, longer loans might seem to make sense. Right now, interest rates on five- and six-year car loans can be, if anything, lower than traditional three-year ones. (You can compare auto loans in your area by using the Bankrate auto loan tools.)

Longer-term loans can have a big impact on cash flow. Monthly payments on a five-year $25,000 auto loan with a 6.5 percent interest rate are about $489. That compares with $766 per month for a three-year loan at the same rate. Going to six years will bring payments down to $420. That can be a huge difference to someone on a tight budget.

Unfortunately, there's no free lunch. Although your monthly outlay is lower, you'll pay much more interest over the life of the loan -- $5,258 on a six-year note -- more than twice as much as on a three-year contract.

How you get upside down
Those who opt for long-term financing, especially in conjunction with automakers' little- or no-money-down deals, may also face a nasty surprise if they trade in their cars before they are fully paid for.

Since they are paying mostly interest, rather than principal, each month, and because new cars and light trucks depreciate most in the first two or three years, owners are likely to find that the trade-in value of their vehicles after three or four years is less -- often much less -- than what they owe on them. In the terminology of the car trade, the loan is "upside down." Edmunds.com, the online auto-buying guide, estimates that 40 percent of consumer car loans are upside down, by an average of $2,200.

A similar shock may await those whose cars are stolen or totaled. When a vehicle securing a loan is deemed worthless, the lender will rightly demand immediate payment of the full outstanding balance.
Unfortunately, collision and comprehensive insurance policies will generally reimburse an owner for no more than a car's book value. If that's less than the amount owed on the loan, the owner is responsible for the difference.

Sometimes individuals with upside down loans can find lenders willing to package the unpaid balance on their old vehicles with the financing of new ones. In these cases, the buyer of a new car is usually taking out a car loan greater than the purchase price of the vehicle. That loan is seriously upside down from day one. Such buyers are also apt to choose long-term loans to keep payments low, which compounds their financial problems, contributing to a cycle of upside down financing that is difficult to escape.

Avoid getting upside down
Longer-term auto loans have lower monthly payments, but they can keep you upside down -- owing more than the car is worth -- on the loan for a longer time, too. These tips will help you avoid, or get out of, being upside down on your loan.
9 tips to help manage your car loan
1. Make a down payment of at least 20 percent of the vehicle's cost.
2. Do not finance the taxes and fees.
3. Take out the shortest-term loan you can afford.
4. Don't take out a loan that's longer than you intend to keep the car.
5. Consider gap insurance.
6. Buy a used car instead.
7. Keep the car until its value matches or exceeds the balance on the loan.
8. Buy cheap.
9. Sell your car yourself.

1. Make a down payment of at least 20 percent of the vehicle's cost.
A down payment of 20 percent is enough to cover taxes and a large portion of the first-year depreciation. Given initial depreciation, your loan might be upside down for a few months, but when it comes time to get a new car, you'll have enough equity in it to make a nice down payment.

Next: "If you must finance for more than five years ..."
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