Here’s How to Get Out from Underwater Car Loan
When a car owner owes more on their auto loan than what the vehicle is worth, they are said to be ‘underwater.’ Other terms include being ‘upside down’ on the loan or having negative equity. No matter what term is used, having a vehicle that is worth less than what is owed is not a good financial setup.
If the car owner needs the vehicle for a trade-in, they will actually have to find a way to pay the dealership or perhaps roll the negative equity into a new car loan. Being underwater means that the car is a liability, not a potential windfall. There are two ways to get out from underwater car loans and breathe a little easier:
- Refinance the current loan
- Pay more each month on the current loan
Unfortunately, buyers don’t really have any other options, unless they can pay off the vehicle completely. When a car is underwater, the owner has to find a way to pay more in principal to build equity.
How to Refinance a Loan
Refinancing a loan isn’t difficult. Car owners might refinance at their current bank or credit union. Refinancing will require a credit check. This helps the lender better understand the individual’s credit risk.
The benefit of refinancing the loan is that the car owner could be approved for a loan with a lower interest rate or a loan that is shorter in duration. Both of these options can help the car owner pay down the principal quicker.
However, car owners should understand the value of their car. They can research the value via Kelley Blue Book. Knowing a car’s value can help buyers better understand how much they need to pay down to build equity.
Even when a buyer refinances, equity isn’t going to appear immediately. If a car is substantially underwater, car owners might need to pay down more principal each month to make a dent in the negative equity.
Pay More Each Month to Chip Away Principal
Refinancing might allow a car owner to have a lower interest, which could decrease payments. However, paying more each month towards the principal can help with an underwater loan.
When a car owner wants to pay more in principal, they can call their lender and ask how to make the payments to apply any extra amount to the principal. Some lenders automatically apply an extra amount to the principal.
However, to be certain that the payment is being applied correctly, car owners should speak with the lender about payments.
Car owners may be underwater on their car even if they have a great interest rate and a typical loan term. Why is this?
- A low or nonexistent down payment
- Rolling another car loan into a new car loan
- A longer loan period
How Low Down Payments Can Push a Loan Underwater
Ideally, when purchasing a new car, the buyer should put 20 percent of the purchase price as the down payment. This down payment amount helps cover the depreciation of the vehicle. The recommended down payment for a used car, though, is only 10 percent of the purchase price.
When a buyer can only make a small down payment—or none at all—their loan may reflect nearly the entire purchase price. Since cars depreciate the most during the first few years, the loan may be more than the value of the vehicle.
Why Rolling a Previous Car Loan Into a New Loan Isn’t a Great Idea
Some car buyers need to upgrade their old car to a new model. However, they could be still paying off their trade-in vehicle. Some dealerships might roll in the amount that is left on the old vehicle into the loan for the new car.
The buyer will continue to pay what they owe for their old car; the price will just be on top of the price of the new vehicle. When a trade-in has negative equity, the buyer still owes that money.
Rolling that extra amount into a new car means that the new car could be instantly underwater. The difference between the value of the new car once it drives off the lot and the amount owed on the loan could be significant.
When possible, car buyers should pay off their current car before buying a new vehicle. If they can’t pay off the full balance on the loan, they can use KBB to find out the value of that trade-in to learn if the value of their trade-in vehicle is more than what they owe.
How a Longer Loan can Sink the Buyer
Choosing a loan that is longer in duration could let the buyer pay less each month. However, those cheaper monthly payments could lead to a sinking reality. Longer loans mean that the buyer will pay more in interest; the loan also could lead to the car being underwater in the beginning of the loan.
Depreciation is most significant early on. Longer loans might have smaller principal payments, and this means that it can take much longer for a car owner to build up equity in the vehicle. A car owner with a longer loan (e.g. 84 months) and who only had a small down payment could be underwater immediately.
Understand Financing Options When Buying a Car
One of the best ways to avoid being upside down in a car loan is to research financing options when buying a vehicle. Use KBB to research the value of a trade-in and understand if it’s worth more than what is owed. If there isn’t an outstanding loan on the trade-in, understanding the value can help the buyer know how much more money might be needed for a down payment.
A 20 percent down payment can help decrease the impact of the car’s value depreciation. In addition, opting for a shorter loan term helps ensure that buyers pay down the car faster, and build equity sooner.
Sometimes, though, buyers need a new car and might not have the financial means to make a 20 percent down payment. Those who are in a tight financial position can use sites like Carzing to find a car in the budget and get pre-qualified for financing, too.
Carzing will show buyers all the financing options for which they might qualify. Buyers can look through their options to better understand their interest rates and potential monthly payments. Carzing also will help buyers understand their down payment expectations, too.
Getting pre-qualified can help buyers feel empowered in the buying process. A new (or used) car is an expensive purchase; the search can be frustrating for first-time buyers, and applying for financing can be a bit stressful, too. With Carzing, buyers can handle their car search and their loan hunt privately and from home.
This allows buyers to visit the dealership knowing the car they want and the financing that they’d prefer. The visit to the dealership can focus on completing the credit application, taking a test drive of a favorite vehicle and, ideally, finalizing the purchase.