How to get out of an upside-down car loan

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If you are shopping for your next new or used car and know you’ll be financing at least a portion of the loan, do some careful planning to avoid being upside down on your loan, or to at least minimize the time that you are in this precarious financial state.

What is an upside-down car loan?

A car loan becomes upside down when you owe more on the loan than the vehicle is worth. For example, your loan would be upside down if your SUV’s value is $12,000, but your loan balance is $15,000. This means you have negative equity of $3,000. This isn’t a problem on its own — if you plan to keep the vehicle and make payments until the loan is paid off. However, you might be wondering how you reached this point.

How to get an upside-down car loan

The truth is it isn’t difficult to find yourself in this position. Perhaps, you financed the vehicle with no money down. While this seems like a good idea at first, consider this: Within the first year of ownership, vehicles can lose as much as 20 percent of their value. Therefore, it won’t take long for the depreciation of your vehicle to overtake your equity, even if you’ve been making payments on time.

Another way people find themselves with an upside-down loan is by taking a car loan with a longer repayment term. Some lenders allow borrowers to finance new cars for up to 84 months (or seven years), so at some point during the repayment process you may owe more than the vehicle is worth.

Remember, in the early years of the loan, a bigger chunk of your payment goes toward interest rather than building equity in the vehicle. Similarly, the higher interest rate you pay, the more you’ll pay to the lender in interest and the less that goes toward paying down the principal value of the auto loan.

Ways to reduce your vehicle’s negative equity

While these things do happen, there are steps you can take to cope with or get out of an upside-down car loan, so if you ever want to sell or trade in your vehicle, you can do so.

Here are some steps you can take to reduce your car’s negative equity:

  • Receive a payoff quote: Ask your lender how much you owe on your vehicle.
  • Know how much your car is worth: Kelley Blue Book’s trade-in value gives you a low estimate of what your vehicle might be worth if you decide to trade it in. A private-party sale value, however, may net a higher price for the car.
  • Do the math: Using the trade-in or private-party sale estimate and your lender’s payoff, find out your vehicle’s equity.
  • Make extra payments: If you plan to trade in your vehicle in the future, you can make extra payments to pay down the negative equity.
  • Pay it off: Conversely, for those planning to keep their vehicles, continue to make payments until the loan is paid off. Once the loan is paid, whatever remaining equity the car has can be turned into cash via a sale or trade-in.
  • Get gap insurance: Make sure you have Gap insurance just in case your vehicle is totaled. This coverage fills in the gaps (to a percentage) between what your insurance company pays for the vehicle and what you owe on the loan, so you’re not left with a big bill.
  • Explore other options: You could refinance your loan into a shorter term and lower interest rate. This will ensure that more of your payments go toward equity, which will help you catch up quicker.

How to avoid getting an upside-down car loan

Choose a car that holds its value better: Different makes of cars hold their value better than others and selecting a car that will depreciate more slowly will shorten the length of time you are upside down in the car loan. As you research what car to buy, look at the ownership costs listed for each car on an independent car information website to see the differences in the depreciation among your top few choices.

Plan to pay the taxes and fees outright: Rolling these additional charges into your loan automatically puts you upside down, since you’ll be financing more than the car is worth.

Aim to make a down payment: Because the first year of depreciation of a new car is the greatest, making a down payment can offset the length of time you’ll be upside down. Try to put down 20 percent of the total cost of the car, including taxes and fees. You may not have to come up with as much cash as you think because cash-back rebates offered by the manufacturer and any equity you have in your trade-in count toward that 20 percent down.

Choose a loan that equals the length of time that you’ll likely keep the car: If you trade in your car before it’s paid off and you are upside-down, you’ll need to either pay cash to pay off the loan or the payoff amount will get rolled into your next loan. That will automatically put you even further upside down in your next car.

Shop around for the lowest interest rate possible. Consult the manufacturer’s website for any cut-rate financing deals, as well as your local credit unions and any banks where you have an account. Also, you can use Bankrate’s loan comparison tool to find the best rate for you and the car you want to buy.

If you are buying a new car, you may still end up upside down in the car loan for at least a short time. Compare the depreciation values listed for the car on an independent car information website to the amortization table in Bankrate’s auto loan calculator to see how long you will be upside down in the loan. And consider buying gap insurance to cover you during the upside-down period of the car loan.