Upside Down Car Loan

Rising fuel prices, longer car loan terms, and rolling-over debt from prior vehicles can all contribute to a condition known as an upside down car loan.  And when this happens during a credit crunch, it's hard for consumers to escape this financial burden.

In this publication we're going to discuss what are called "upside down car loans."  We'll provide a detailed definition of this term, explain how this can happen to consumers, and discuss some strategies you can adopt to get out of this condition.

What is an Upside-Down Car Loan?

An upside-down car loan goes by many names.  Sometimes they're referred to as "underwater loans" but perhaps the most the most descriptive term is a "negative equity" position in a car.  Whatever it's called, the term simply means you owe more to creditors than the car is worth if it were sold, or negotiated during a trade-in deal.

Fundamentally, we all understand that a car depreciates over time.  That is to say, as the car ages, the value of the car drops.  There are always exceptions to this rule, but we're not talking about collectible cars - we're talking about the average car you'll find in showrooms today.  And the more miles you drive that vehicle, and the longer you own it, the less it is worth on the marketplace.

Causes of Upside Down Car Loans

So even under normal conditions we would expect a car's value to decrease over time.  But what many consumers don't realize is that when this value drops below the remaining principal balance on a car loan they've gone upside-down on their loan.  The car's value has dropped to the point that if they were to sell the vehicle, they wouldn't have enough money from the sale of the car to pay off their loan.

There are a several of conditions, or causes, of upside down loans.  Some of these conditions are caused by the driver / owner of the vehicle, while others are the result of market conditions:

• Fuel Prices - a rapid rise in fuel prices can result in a rapid decrease in the value of gas-guzzlers.  The value of sports utility vehicles (SUVs), and trucks are especially vulnerable to fuel prices due to their lower MPG fuel efficiency.
• Long Commutes - since a car's value is a function of both the age of the vehicle as well as mechanical wear, commuters that rack-up many miles driving back and forth to work each day will rapidly lower the value of their cars too.
• Poor Satisfaction Ratings - if a certain make or model of a car gets poor customer satisfaction ratings from existing owners - usually because of poor quality or design - then the depreciation rate of that vehicle may drop faster than an average car's.
• Small Down Payments - while it may be more desirable to make a small down payment on a car, you're automatically starting out with less equity than consumers that are willing to put down more money.
• Debt Rollover - even worse than a small down payment, rolling-over a prior car loan's balance into a new loan only exacerbates the problem.
• Long Loan Terms - finally, the longer it takes to pay down a car loan, the greater the chances that the loan will go upside down as the table below demonstrates.

Upside-Down Car Loan Example

This example demonstrates how the length of a loan can turn a car loan upside-down.  Here we're showing a $22,000 car loan carrying a 7% interest rate at the end of 24 months.  At the close of this timeline, the car is now worth only $14,000; however, the five-year loan still has $14,108 of principal remaining.

Dealing with Upside Down Car Loans

If you own a car that's worth less than you owe creditors, then there are steps you can take to help yourself.

• Gap Insurance - if you owe more on the vehicle than your car insurance company will pay, then it may be the right time to buy gap insurance.  Gap insurance provides coverage for the difference between what is owed on a vehicle and what an insurance company says it is worth in the event the car is involved in an accident.
• Larger Down Payments - before you buy you next car, truck, or SUV, make sure you can really afford the vehicle.  A large down payment significantly reduces the chances that you'll find yourself with negative equity in your car.  While a 10% down payment is good practice, putting 20% down is even better.
• Shorter Loans - shorter terms on a car loan will help to ensure your pay-down of principal isn't outpaced by the rate of the car's depreciation in market value.
• Keep the Car - if you hold onto the car long enough, you'll eventually pay off the car loan.  At some point you'll flip the car loan back around and actually start building equity in the vehicle once again.

If you're desperate to get out of an upside-down car loan right away, then there is really only one viable option - sell the car.  Even if you sell the car, you're going to have to pay off the proceeds of the loan.  So in the end, you might want to just hold onto the car and pay off the loan.

If you're thinking about stopping payments on the loan and having the car repossessed, then there is an important law you need to know about.  In many states, a creditor or lessor that has followed the correct repossession and subsequent sale of the car process is allowed to sue you to collect the monies required to pay-off any outstanding balance on the loan.  Therefore, by allowing the car to be repossessed, you are needlessly harming your credit score and may even wind up paying attorney fees too.

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