Upside Down Car Loan TrapValley Auto Loans » Articles » Personal Finance » How To Avoid an Upside Down Car Loan Previous Next Last Updated On: October 19, 2016
Upside Down Car Loan Equity Trap
- 1 Upside Down Car Loan Equity Trap
- 2 Negative Car Equity Solutions
A negative equity car loan is a trap that vehicle owners should do their best never to fall into. Even if you have a low-interest car loan with low car payments, it is tough to escape negative equity or an upside down car loan. Getting another bad credit car loan to replace the current car loan is only going to make it worse. But what if you need it to get another car?
What Is a Negative Equity Car Loan Balance?
Essentially, negative equity is when you have an asset used to get a loan that is worth less than the loan itself. In the auto loan business, this is also known as an upside down car or an underwater car loan.
That means having a car that is worth less than the car loan used to purchase it or an upside down car loan. This is typical because the value of the car will change over time. Having the value of the car decrease faster than you can pay off your loan will eventually put you upside down and leave you with negative equity car value.
When this happens, people start looking for advice on how to get out of a car loan that has negative equity. The Federal Trade Commission has more information on negative equity in the auto business. 1
Why does this happen?
It is easy to fall into the trap of trading in vehicles you have not paid the loan balance off on and rolling loans together to get a larger payment. One of the main reasons consumers wind up with a negative equity car is long-term auto loans. Offering a lower monthly payment in exchange for longer terms makes the deal sound sweeter when you are at the car lot.
By getting this type of car loan, you run the risk of an upside down car loan, and you will be paying for the most expensive car loan than any other source of financing. It is very likely that you could damage your credit further.
Banks are also collecting interest for a longer period when they offer you more months to pay off your loan, but the value of the car drops faster than the loan amount.
Avoid refinancing your car to get cash out of your car
Another way to go upside down on your car loan is to refinance your loan and take the Cash Back incentive some lenders offer. It sounds like easy money, but the money they offer you is being added to the loan amount. In most cases, you will have additional charges for the service and you will have to pay interest on all this also. You will end up paying much more in the long run.
Rolling a current car loan into another vehicle loan adds the amount you owe on your new loan. Many times this starts a person out with a new upside down car loan. The car dealership will offer lower payments to make it affordable to you, but the new car will depreciate faster than the loan will be paid off. You will have negative equity car value for the life of the loan.
Upside down after a bad lease buyout deal.
If you have leased a car and are at the end of the lease term or you need to buyout the leased car early to avoid penalties you need to check the resale value before buying. The leasing company will assign a residual value to the car at the beginning of your lease term. Many times this amount is exaggerated and will not represent the correct amount of fair market value. Just buying a leased car without checking its proper trade in value could leave you upside down if you finance the lease buyout
Upside down car loan math
Say you have a 2-year loan with your bank or loan creditor. This would leave you paying only about 4% of your loan every month. Now imagine that your new car has lost a quarter of its value in the first year of your loan. You are okay. You will have paid at least that much in the first half-year of your loan. However, stretch that loan out to 60 months and the depreciation will outrace the payments by several months thanks to you only having to pay about 1.5% of the loan monthly. You will be upside-down on that loan quickly.
How to get out of a car loan with my negative equity?
Is it possible to get out of a bad car loan? If you owe more than the car is worth it is possible to get rid of your negative equity car loan and replace it with a high risk car loan. You can get yourself out of deeper debt while you are doing it if the vehicle you buy is sold lower than it is worth.
Sell your car for the maximum amount it is worth and find an honest lender. Pay attention to what you are buying and selling. You may even be able to get your FICO score up while paying off the loan on your new car, so be careful.
Negative Car Equity Solutions
Sometimes, you do not have any choice but to take the negative equity of your current car loan payoff and roll the remainder into the car loan you are replacing it with. In this situation, even though your old car is gone, you are still paying for it while you are paying for your new upside down car loan.
By the way, the new car is also going to go down in value during that time. If you are not careful, you may wind up paying more than what both cars are worth. Your only recourse is to pay off as much of the new car loan balance as possible and offer as large of a down payment as you can.
Car buying scams are everywhere, even at the largest and most trusted dealerships. You are not going to get an ideal interest rate with a negative equity car loan. Do your best to avoid this trap when you are considering financing your car or any equity loan trade.
If your current negative equity car still runs, it does not make sense to roll it over into a new car loan. Of course, you may get incredible gas mileage on your new option or better insurance rates. If so, it may make up the difference. If not, stick with the money pit you have or sell it for the amount you owe and start with a new car loan. With your next purchase, build a simple budget that will help you get a good down payment and help with the car payments until you refinance with a better APR or find a new car.
Can I get an upside down car loan to roll my loan over?
It is always going to depend on the car, the existing loan, and the lender. The bad credit bank is likely to use NADA 2 or Kelley Blue Book 3 to assess the value of the vehicles. Then, the bank will probably allow the car dealer to sell for around 15% more than the trade-in price listed in the guides you checked. Car dealers that exceed the 15% could put you in a situation that can damage your situation further. Only western banks use Kelley, but you may want to check the values yourself in both guides, no matter where you are.
Is the dealer being ripped off?
The simple answer to this question is no. A dealer is not going to do business with you if he cannot make a profit. The idea is to make it so the selling price (remember, it is about 15% over trade-in value) will pay for the negative equity on the existing loan that the lender is buying. The dealer may get some wiggle room at the selling price to accommodate you, but you should be prepared to get a no, if not.
Okay, a negative equity car loan looks pretty darn attractive when you are standing there next to a shiny new car. You know you will be still paying off more than it is worth. However, you should avoid rolling negative equity into a new loan at all costs. You are going to get a high-interest rate on your new loan, and you are likely to wind up in negative equity on that one as well.
All of your bad credit bundled up in one neat package, but it is still a neat package of wrong investment strategies with high monthly payments for a long time. The longer the term, the greater the chance of default and car repossession by the creditor.
Now, a significant cash down payment can lower the negative equity you are rolling into your new loan a lot. If you can manage this, you may even wind up with a trade in instead of shooting yourself in the foot. You can start this process by looking at your budget and start building your plans for a big down payment. A simple budget can show you how to pull extra money from the income you already have.
In short, unless you have to do it, never, ever roll negative equity into an upside down car loan. You are not going to be the winner in that situation. Knowing how to get out of a car loan that is upside down so hard to do. Do your best to keep your old car on the road and not funneling money out of your wallet until you can manage to pay it off or sell it. Use a large down payment for the next car loan and get a 36 to 60 month or less auto loan to avoid an upside down car loan.
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Sources and Citations:
- http://www.consumer.ftc.gov/articles/0257-auto-trade-ins-and-negative-equity ↩
- http://www.nada.com/ ↩
- http://www.kbb.com/ ↩