Don't get stuck upside-down in your auto loan
By Greg McBride, CFA • Bankrate.com

Being upside-down on an auto loan, or owing more than it is currently worth, can be detrimental to your financial health.

Anyone who has ever bought a car has been there, at least for a little while, as cars depreciate the fastest beginning the moment they are driven off dealers' lots.

But for some people, being upside-down in a car loan is changing from a temporary condition to a permanent one. This is largely due to two reasons:

1. The American consumer's penchant for newer, bigger, more expensive automobiles; and
2. The tendency for borrowers to "payment shop," evaluating purchase and loan alternatives on the basis of monthly payments. Lenders' willingness to finance these loans on terms of increasing length, such as six, seven, or even eight years, makes monthly payments more attractive than on shorter terms.

Borrowers with budgets already strained by servicing existing debts are all the more susceptible to the "payment shopping" affliction. But it leads to the borrower staying upside-down in the loan for most of its life, because the first years' payments go mostly to interest, while the car continues to depreciate. You don't owe less than the car is worth until the loan is nearly paid off.

Upside down means one of two things when it comes time to get the next automobile.

The first option has the borrower writing a check for the outstanding loan balance when trading in the vehicle. Presumably this is money the borrower did not have when the vehicle was purchased, as the borrower could have made a larger down payment or taken a shorter loan term at a lower rate, and used that savings to make higher monthly payments. But for borrowers who have since accumulated this savings, they can also pay ahead on the loan so that what they owe more closely resembles the current value of the vehicle.

The other option involves rolling the negative equity balance into the next loan. Lenders are more than happy to do this, as they can lend more money and charge a higher rate to reflect the added risk. The borrower is then back into the early years of a new car loan, already owing more than the cost of the new vehicle at a time when that vehicle is going to depreciate the most. If you get the vision of a snowball rolling downhill, you're on the right track.

So how does one avoid getting caught in this financial avalanche?

First, don't excessively stretch the loan term. Longer loan terms mean lower payments, but they also mean more payments, and more payments at a higher interest rate than shorter-term loans. Consider making a larger down payment, not only to reduce the amount borrowed, but also to take advantage of more favorable financing that exists on shorter loan terms. A larger down payment also provides some cushion from being upside-down, given the accelerated depreciation in the first years of the loan.

Now this is certainly no guarantee that you won't be upside-down for at least some period. But to avoid being upside-down in the future, when the hankering for a new set of wheels strikes you, plan on keeping the vehicle longer. In the first few years of the loan, the value of the vehicle depreciates faster than the loan balance declines. Fortunately, this process reverses itself the longer you keep the vehicle, with the loan balance coming down much faster than the value of the vehicle in later years.

Finally, don't buy too much vehicle for your budget. Consider a used (or in industry parlance, "pre-owned") vehicle that has already hit the previous owner with the bulk of the depreciation in the early years of the vehicle's life. The lower price facilitates a shorter loan term and brings you closer to putting car payments in your rearview mirror.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Personal Finance Advice channel on Bankrate.com.