Upside Down and Underwater on a Car Loan

Imagine learning that you owe $13,000 on a vehicle that is only worth $10,000. While you might be disappointed, angry or confused, one thing you wouldn't be is alone. Nearly a third of drivers with auto loans are in the same predicament.

Upside Down or Underwater

Owing more than the vehicle's value on a car loan is known as being "upside down" or "underwater." The gap between the car's value and the amount owed is called "negative equity." Whatever you call it, it can be trouble if you're trying to trade in your car for a new one.

Over recent years, we've seen a rise in the number of people underwater, as well as the amount of negative equity they have in their cars. In 2012, for example, only about 23 percent of cars traded in were worth less than what was owed on them. Compare that to the last quarter of 2017 when the 32.5 percent of trade-ins had negative equity. The amount of negative equity has also increased, up from $4,500 in 2015 to $5,100 in 2017.

If you're upside down, we've got some tips to help you fix the situation. But first, let's take a look at how this happens.

Going Upside Down

New cars lose a good chunk of value in the first few years of ownership. That loss in value happens so quickly and can be so substantial that, without a significant down payment to offset the immediate depreciation, it can take years of regular payments to reduce your loan balance enough to match the car's value. And with today's long loan terms, hitting that break-even point takes longer than ever.

If you have to trade in before the end of the car loan and you decide to roll $3,000 of negative equity into the next new car, the vehicle's price increases by $3,000. Now you're really upside down. It can be a hard cycle to escape.

Getting Right Side Up on Your Car Loan

Carrying over negative equity to another car loan might seem like the only option, and sometimes it is. But before you proceed, know that every thousand dollars you roll into the next loan can easily increase the monthly payment by $20. That means carrying $3,000 over to a new loan would result in a payment that is about $60 more per month than it would be if there was no negative equity tagging along. Instead of saddling yourself with more debt, try these three approaches:

1. Stick with the car you have: It might make more sense to make payments on a car you don't love for a few months (or even years) than to have extra-high payments for five, six or seven years. So if possible, stay in your current car with its current loan. Stick it out until you have equity, hit the break-even point on your balance, or come close to it. If you can make larger payments to your lender, that will help reduce your loan balance faster, letting you trade in sooner. If you're simply trying to get out of a high payment, it may make more sense to refinance your current loan than to get a new car. Make sure you compare interest rates among lenders before making a decision.

2. Buy a new car or truck with a big rebate: If you need to get out of your underwater car right away, consider buying a vehicle that has a hefty cash incentive offer. A cash rebate will help offset your negative equity. Some car companies offer extra loyalty rebates for shoppers who stay with the same brand of vehicle. Other companies offer "conquest" rebates. That means they will give you an extra discount if you're coming to their brand from a competitor. Making a stronger down payment will increase the chances the lender will approve you.

It's worth noting that vehicles with deep rebates often depreciate more quickly than average cars do. So although the rebate tactic will work, it is only advisable if you're confident you'll keep this new ride until it is paid off, or close to it. If you decide on an early trade-in for a vehicle with a fat rebate, chances are good you'll be in a worse financial position than when you started.

3. Lease a new car with a big rebate: Rolling over the negative equity into a lease might also make sense. Since lease payments tend to be lower than traditional car payments, you might not feel the sting of the negative equity penalty quite as much. And when the lease is over, your negative equity will be gone, too. Just as with a purchase, you should only go this route if you're confident you'll stick with the lease. If you should decide on an early trade-in, you'll still be in a bad spot. A larger down payment will be helpful in this scenario as well.

Don't Let Upside Down Get You Down

Sometimes you can't avoid the life changes that affect your vehicle needs. But if you understand how negative equity works and how to manage it, you will have the best chance of getting above water and right side up.