What Does It Mean To Be Underwater on a Car Loan?
When you take out a loan for a car, it’s a good idea to make sure that the value of the car exceeds the total balance of the loan. Otherwise, you may find yourself facing financial challenges if you want to trade in the vehicle or if you total it in an accident. Additionally, you may just struggle to meet payments.
What Is an Underwater Car Loan?
An underwater car loan, also known as an upside-down car loan, is a situation in which the amount you owe on the loan exceeds the value of the vehicle for which you’re paying. Another term for this situation would be “negative equity.” Take, for example, a lessee who has a car currently valued at $15,000 but has a loan balance of $16,000 on the vehicle. This person would be $1,000 underwater on the loan. If they sold or traded in the vehicle at its maximum value, they’d still owe money to the lender.
The opposite of being underwater on a car loan is to have positive equity on your vehicle. With your vehicle having more value than the amount you owe on it, it becomes an asset that you can leverage to your advantage. In the above example, if the values were reversed—$16,000 in value and $15,000 left on the loan—the lessee could sell or trade in the vehicle and receive $1,000 in credit or cash to put toward another car.
How Do You Become Underwater on a Car Loan?
There are several ways that people become underwater on their car loans. Here are some common scenarios:
Forgoing or Under-Contributing a Down Payment
Providing a down payment reduces the size of the total loan, thus putting more space between the amount you need to pay back and the value of the car. If you receive a loan without any money down, you could become underwater on your loan almost right away. This is because vehicles depreciate by about 20% as soon as they leave the lot, so anything less than a 20% down payment is risky.
Imagine, for example, that you pay 10% down on a $25,000 sedan and cover the remainder with a loan. Once you drive off with the car, its value drops to $20,000, which is $2,500 less than the total balance of your loan. The car will continue to depreciate even as you pay off your loan. Unless you pay off large sums at a time, it’s unlikely that you’ll end up with positive equity on the vehicle.
Overpaying for the Car
For similar reasons, overpaying for your vehicle can also lead to going underwater. When you overpay, you spend more money for the product than it’s worth, so the true value of the vehicle you’ve bought is lower than you thought it was. Compounded by the immediate depreciation of the vehicle after leaving the lot, overpaying can put you even further underwater. That’s why it’s important to conduct adequate research about the value of a vehicle and to buy from dealerships that offer reasonable prices.
Taking on Long-Term Loans
In some cases, the length of a loan period can lead you underwater. The average length of an auto loan is about six years, which is generally manageable in terms of staying ahead of the rate of depreciation on a vehicle. Longer loan lengths, however, essentially give your vehicle more time to decrease in value before you can sell it or trade it in, so the depreciation outpaces your payments.
Rolling Over a Loan
If you decide to purchase a new car while you still owe money on a current vehicle, you may have the option of rolling the unpaid balance into another loan for the new vehicle. When this happens, you may end up with more loan balance than you can reasonably pay off before the car’s value dips below it.
How To Get Out of an Underwater Car Loan
Should you find yourself underwater on a car loan, there’s hope. Here are some solutions for getting out from underwater:
The simplest solution is just to keep paying off your car loan, regardless of where it stands in relation to the vehicle’s value. You may be underwater for a while, but you will own the car once you service the loan in full. At that point, you’re no longer underwater. Rather, you have equity, and any amount for which you sell the vehicle is yours to keep.
Another solution is to try contributing as much as possible per payment period. This would allow you to service the loan more quickly and outpace the rate of depreciation on the vehicle while building equity. However, before you decide to proceed with this solution, review the terms of your loan to make sure there aren’t any fees associated with the early repayment of your loan.
The third option is to sell your vehicle to a private buyer. A private sale is more likely to net you a larger return compared to a trade-in at a dealership. In the best of cases, you can sell your vehicle at a cost that meets or exceeds the value gap. More commonly, the return you get from selling your car may still put you short of the loan balance, but you do have a better chance of minimizing the amount you still owe to the lender.
When you refinance a loan, you replace an existing loan with another, thus revising the terms of the loan, such as its interest rates and schedule of payments, for example. This can facilitate the process of getting out from underwater if the current interest rates are better than when you took out the original loan. You’ll be able to manage payments better and potentially pay off the loan more quickly.
The best solution for an underwater car loan is to avoid getting underwater at all. To do so, it’s important to get the best terms and rates on your loan and repayment plan. Complete our contact page, call us at 330-752-8884, or visit us at 1875 Brittain Road to discuss our auto finance services. Together, we can get you in the car you want under conditions that are ideal for you.