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WHAT ARE “UPSIDE-DOWN” CAR LOANS? AND WHY YOU NEED TO AVOID THEIR DANGERS

Presented by Mory Brenner, Esq. & Keith Hassenpflug

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 merry-go-round!

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:

  1. Pay the “deficiency” off when you trade or sell the car with the upside-down auto loan.
  2. 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.
  3. Roll the deficiency into your new car loan. Be sure to re-read the dangers of this choice in the text above.
  4. 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.
  5. 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 able to.
  6. 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.
  7. File bankruptcy, you can give back the car and have the deficiency from the car loan wiped out if you qualify under the bankruptcy code.

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