Auto Refinance: Upside Down Loans Don’t Have to Stay Underwater

With an upside down loan, the borrower owes more than a home or an automobile is worth. This also is known as being underwater or having negative equity. With auto loans, upside down loans are problematic because the loan can perpetuate a state of negative equity.

When a borrower is upside down on a loan, there could be options to help build equity and come up for air. With an auto refinance, upside down loans can possibly become manageable.

How Upside Down Loans Can Perpetuate Negative Equity

No borrower enters a loan to have negative equity. An upside down loan can happen because of a number of factors, including:

• Rolling an old loan into a new car loan

• A minimal down payment

• Opting for a longer loan term

• Taking out a second loan for the car

Rolling an Old Loan into a New Car Loan

Cars only hold so much value. When an individual buys a new car, that car will depreciate quickly; the vehicle will even lose value once it drives off the lot.

Sometimes buyers are in a position where they need a new car but the old vehicle hasn’t been paid in full. Maybe the car just isn’t reliable any longer and they need to upgrade. Car owners may find that they don’t have the financial means to pay off their current loan even though they need to buy a new car.

What’s the solution? Unfortunately, some buyers opt to roll the balance of the old loan into the new car. In this case, the new vehicle will be worth less—sometimes significantly less—than the amount owed on the loan.

The difference between the amount owed on a loan and the value of the car is the equity value. If the loan balance is higher than the value of the vehicle, the car owner has negative equity and is underwater in their loan.

Rolling an old loan into a new loan could possibly perpetuate a longstanding state of negative equity. As the car buyer owes more than their car is worth, the next new car might need to carry that balance of that previous loan too. If buyers can’t pay down what they owe when buying their next new car, they could continue to deal with upside down loans.

A Minimal Down Payment

Money Crashers explains that buyers that only have a small down payment—or no down payment—will face negative equity in their car loan because they will owe nearly the full purchase price. Cars depreciate quickly, and the worst depreciation is in the first three years.

To avoid being upside down on a loan in the beginning, buyers should aim for a 20 percent down payment for a new vehicle. This can include the value of a trade-in.

Choosing a Longer Loan Term

In the past, the average car loan term was about three to five years. Now most buyers opt for six year loans. To keep monthly payments low, some buyers choose longer term loans.

Experian explains that loan terms are six and seven years put buyers behind. These loans may lead to the buyer not being able to pay down enough principal as the car depreciates. A long-term loan can then cause the buyer to be upside down during the early years of their loan.

Sometimes, though, buyers need a loan with lower monthly payments. Some buyers also might not want to sacrifice the car they want for a lower-priced car that can be paid off in a shorter period of time.

Taking Out a Second Loan

A job loss or unexpected expenses could leave an individual scrambling to find money. They might opt to take out a title loan against their vehicle.

These loans allow consumers to borrow against the equity in their car. They typically include higher interest rates and are meant to be paid off quickly. However, not all borrowers can pay them in a short period of time, and this leaves their car with no equity or possibly with negative equity.

Auto Refinance: Upside Down Loan Can Flip Right Side Up

If a consumer realizes they are underwater in their auto loan, there are possible options. Refinancing an auto loan can help consumers possibly secure lower interest rates or more favorable loan terms.

If an individual’s credit score was less than stellar when they purchased their vehicle, they might have a higher interest rate on their current loan. To keep payments lower, they also could have opted for a longer loan term.

Refinancing doesn’t always guarantee that a consumer will receive a more favorable interest rate. However, consumers who are underwater might investigate their options.

Even when a consumer refinances their loan, their equity situation probably won’t be improved overnight. However, if the new loan offers a lower interest rate, the consumer can allocate more to the principal. A shorter loan term lets consumers pay off that vehicle sooner.

Paying off a loan quickly means that the consumer won’t face monthly payment obligations and the value of their car represents equity instead of potential debt.

Consumers with an upside down loan can refinance through their bank, a credit union or another lender. Car owners might shop around to find their best options and the lowest interest rates.

Buy a New Car with the Best Loan Terms

To prevent being underwater for a car loan, car buyers should try to allocate a 20 percent down payment for their purchase and choose loans that don’t extend beyond five years.

Interest rates also impact monthly payments, and consumers with poor credit might face higher interest rates that lead them to lengthen their loan term to keep payments reasonable. This could mean that the buyer is underwater at the beginning of the loan.

Before committing to a loan, though, buyers can use sites like Carzing to get pre-qualified for financing and understand all their loan options. Getting pre-qualified lets buyers see all the loan options for which they might qualify.

Buyers can review the loan lengths and the monthly payment obligations. Carzing also shows buyers the expected down payment for the loan. When buyers use Carzing to get pre-qualified, they can add in the value of a trade-in. The trade-in will be reflected in the financing.

Carzing also lets car buyers find a vehicle that meets their budget needs. Search for a car by make/model, price or body type. When shopping for a new vehicle, buyers should understand their budget and searching by price could be an ideal option to ensure that all options are affordable.

Trying to buy a car that stretches the finances could lead buyers to choosing a longer loan and being underwater. Nerdwallet recommends spending less than 10 percent of monthly take-home pay on a car payment. Take-home pay is the amount received after taxes and other deductions.

While no buyer plans to be upside down on their car loan, sometimes circumstances arise when they need a longer loan, they can’t afford a large down payment or when they have to roll an old car loan balance into a new option. However, refinancing a car loan could help buyers who are underwater to secure more favorable interest rates and loan terms that let them pay off that loan faster.