Your family has grown out of that to door sports car you purchased
last year. So you bought the wrong vehicle, what’s the big deal?
You’ll just get a new mini-van that will make family life in
it a lot more convenient. The twins have put a strain on the cash flow,
but what the heck. You’ll just finance the whole thing and get
the automobile you need. So you go to the bank but they tell you they
can’t do business at this time because you are too far “upside-down”.
What happened? Your credit’s pretty good. You never missed an
auto loan payment. What’s going on here? Let me explain a few
auto loan facts of life and the dangers of being “upside-down”.
When you finance a car you are using it as collateral for the loan.
This makes the auto loan “secured.” The bank or lending
institution will loan an amount based on the car’s current book
value. This book values a car with three different categories, generally:
retail, trade in and loan values. “Loan value” is the lowest,
at about 75% to 80 % of the retail value. There is a reason for this
practice and you should be aware of it.
A new car depreciates rapidly in the first few years. Therefore,
the lender wants the auto loan amount to reflect that depreciation.
The bank or car dealer wants to be sure the outstanding loan balance
always stays less than the “loan value”. For them this
means they can always sell the car for more than you owe if they
have to repossess it. Whenever an auto loan balance is more than
the auto’s “loan value” it is said to be upside-down.
In other words the vehicle isn’t worth the balance. At this
point, in order to sell or trade your vehicle you may either have
to add the difference to the new vehicle loan or make it up with
cash. Without the cash, you’ll be putting yourself in dangerous
position. You see, with good or excellent credit, the lender may
choose to approve the full amount. Be careful what you wish for though.
If you’re “successful” you could find yourself
in so deep, that the upside down car loan cycle lasts for the next
several vehicles. That is, until you keep one car long enough to
pay it down to its real value. Another peril of being upside-down
in your auto loan is that your auto insurance may not be adequate.
That generally only pays off on book values and not on loan balances.
If your car is totaled or stolen you’re again faced with paying
the difference in cash or adding it to the new auto loan. What a
Keep these facts in mind when choosing your vehicle. Make
sure it’s the right one and do not over-finance it. The consequences
may be disastrous. You may have to live with the wrong vehicle, sometimes
for years or you may have to come up with a substantial amount of
cash that could have been better used elsewhere. That kind of grief
can be avoided. All it takes is a little thought and planning.
Here's one more word of advice. You may be tempted or even
be persuaded into financing more than you first intended because
of super low interest rates. The thought here being you can earn
more interest investing in something with the intended down payment
than you would paying out. While this may be true, unless you're
in a position to remedy the deficit at a moments notice, all the
dangers of being upside-down remain. This strategy should be left
to those consumers fortunate enough to have the ability to pay cash
if they want to. For the rest of us the benefits we may get are minimal
and not worth the risk.
Keeping far away from ever becoming an upside-down car loan
statistic does not take a college degree. Follow these steps:
- Pay a substantial down payment when purchasing the car.
The more you put down the less you owe, see how easy it is?
- Do not take too long an auto loan. Avoid a loan that might
last longer than the life of the car. Make adjustments for your
own driving situation. If you drive 75,000 miles a year even a
24-month auto loan might be too long. Some loans last 84 months
to make them affordable, think about what the car will be worth
after 48 months, what you will still owe and the chances you will
want another car before the 84 month car loan is paid off.
- Do not finance the taxes and fees. These don’t add
value to the car and may make you upside down as you drive the
car from the showroom.
- Pay extra principal on your car loan when you can to pay
it off early. Just because they give you a payment amount and a
payment book does not mean you can’t pay extra. Imagine a
60-month car loan on with a $25,000 starting balance and payments
of $495. By paying an extra $105 each to make it an even $600 you
will find you paid the car loan off a full year early. The earlier
it’s paid off the less likely you ever have an upside down
car loan both because the balance of the loan is less and the loan
can not be upside down when it is paid off.
- Do not roll an old deficiency from a previous upside-down
auto loan into your new car loan. This just makes things worse
and more likely if a problem develops the next time it may take
something as strong as a bankruptcy to fix it.
- Do not over pay for the car in the first place. The less
you pay the less you owe the less likely you have an upside-down
auto loan, another easy tip.
- Don’t buy a car you cannot comfortably afford. Sometimes
the upside-down car loan problem comes to a head not because you
need to sell the car early because of the car itself but because
you have to get away from the car loan payment.
- Consider the timing of when you may want a new car and
the likely time to have an upside down car loan. When would a car
loan be most likely upside-down? In the first two years. Both because
during the first two years of any auto loan a higher percentage
of your payment goes for interest instead of reducing the loan
balance and those first two years also proves to be the time of
the fastest depreciation in vehicle value.
I know these things all sound great on paper, and those people
who have read this article and have the luxury of following my advice
I hope will. The tough day at the auto dealer comes when the only
way to finance that car you want is by getting the longest loan,
financing everything and putting little down. I’ve already
said be careful. Just when you think you have no other choice remember
this choice-get a cheaper new car or opt for a used car. Ask the
dealer for alternatives, check your local paper or cars.com online.
If you ignored my advice or found this information after you
already had an upside-down auto loan situation on your hands you
have a few options. I’ll list them in order of least effect
on your credit:
- Pay the “deficiency” off when you trade or
sell the car with the upside-down auto loan.
- Keep the existing car and keep paying on the upside-down
auto loan until you have paid off enough that the loan no longer
merits upside-down status.
- Roll the deficiency into your new car loan. Be sure to
re-read the dangers of this choice in the text above.
- If you have equity in your home consider cashing some out
to reduce the deficiency or catch up. This should be done only
if there is no other way out. Learn more about using your home
equity to help with debt issues first as you could risk losing
your home if you fail to make payments.
- If you are unable to keep up with the current payments,
ask the lender if you can make interest only payments temporarily
or skip a payment. Then go back to choice 2 above as soon as you're
- Give the car back or sell it and negotiate the deficiency.
You may need a lawyer to help with this (which may cost more than
the deficiency) but often you can work out an arrangement for paying
none of the auto loan deficiency, just part of the deficiency or
get the deficiency paid as a 0% interest loan over a number of
years. Depending on the terms you may need to be in tough shape
financially to get this option and it may ruin your good credit.
- File bankruptcy, you can give back the car and have the
deficiency from the car loan wiped out if you qualify under the