What is an upside-down car loan and how do I get out of it?

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An upside-down car loan is a loan in which the driver owes more than the vehicle is actually worth. In order to avoid being upside-down on your loan, or at least minimize the time that you are in this precarious financial state, you may have to make extra payments or adjust your coverage. Here’s what to know

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. In this scenario, you have negative equity of $3,000.

Being upside-down isn’t always an issue, but it can make some things more difficult. For instance, if you want to trade in your vehicle, you’ll need to pay that negative equity. The same is true if your car is totaled. Additionally, having negative equity can make it harder to get a future auto loan with reasonable rates.

With that said, if you’re planning on paying off your car loan in its entirety, being upside-down isn’t a problem — if you make all of your payments, you’ll earn equity over time.

How you end up with an upside-down loan

It isn’t difficult to find yourself in an upside-down car loan situation. Perhaps you financed the vehicle with no money down; while this may be the most financially viable option for you, vehicles can lose as much as 20 percent of their value in the first year of ownership. 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 your car may have depreciated beyond your original purchase point by the end of that period.

Remember, in the early years of the loan, a bigger chunk of your payment goes toward interest rather than toward building equity in the vehicle. Similarly, the higher the 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.

How to find out if your car loan is upside-down

Even though being upside-down on your loan isn’t always bad, it is something to be aware of. You can determine if you have negative equity by doing a little research into your loan and vehicle:

  1. Receive a payoff quote: A payoff quote is a document that shows exactly how much you currently owe on your vehicle, including interest charges. You can request this from your lender.
  2. Know how much your car is worth: Kelley Blue Book’s car value calculator 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.
  3. Do the math: Subtract your loan balance from your car’s value to determine your equity. If the number is negative, you are upside-down on your loan.

Tips on getting out of an upside-down loan

If you ever want to sell or trade in your vehicle, it’s easier to do so if your loan is not upside-down. Here are some ways to reduce your car’s negative equity:

  • Make extra payments: Making an extra payment each month will help you build equity faster, especially if your extra payments go entirely toward the loan’s principal amount.
  • Pay it off: If you’re planning on keeping your vehicle, continuing to make payments until the loan is paid off will eventually result in positive equity. Whatever remaining equity the car has at the end of your term can be turned into cash via a sale or trade-in.
  • Get gap insurance: Gap insurance fills in the gaps (to a percentage) between what your insurance company pays for the vehicle and what you owe on the loan, which helps reduce your bill in the event that your car is totaled.
  • Refinance: Refinancing your loan into a shorter term or lower interest rate will ensure that more of your payments go toward your principal, which will help you catch up on your equity quicker.

How to avoid getting an upside-down car loan in the future

When you take out a new car loan, these steps can help you avoid going underwater on it:

  • Plan to pay the taxes and fees outright: Rolling taxes and fees into your loan automatically puts you upside-down, since you’ll be financing more than the car is worth.
  • Make a down payment: Because depreciation happens fastest in a new car’s first year, 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. Where possible, take advantage of cash back rebates offered by the manufacturer and any trade-in value from your previous car.
  • Choose an appropriate loan length: If you can afford it, choose a loan term equal to the amount of time you’re expecting to keep the car. If you trade in your car before it’s paid off and you are upside-down, either you’ll need to pay the difference in cash or the payoff amount will get rolled into your next loan. That will automatically put you even further upside-down in your next car.
  • Choose a vehicle with slow depreciation: 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 sites like Kelley Blue Book to see the differences in depreciation among your top few choices.

Next steps

Being upside-down on your car loan may be an inevitability, especially in the beginning of your loan term. However, there are ways to minimize the time you spend upside-down. Making extra payments, increasing your down payment amount and refinancing are all viable ways to avoid staying upside-down and start building equity in your vehicle. When you’re shopping, you can use an amortization table to estimate how soon you’ll cross from negative to positive equity.

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Written by
Rebecca Betterton
Auto Loans Reporters
Rebecca Betterton is the auto loans reporter for Bankrate. She specializes in assisting readers in navigating the ins and outs of securely borrowing money to purchase a car.
Edited by
Student loans editor