What Does An “Upside Down Car Loan” Mean?
With tax season in full swing, and many people expecting to get a refund check, it should come as no surprise that buying a new car is often high on the list of many refund recipients. But, with the average price of a new car hovering just over the $36,000 mark, it means that even with a sizeable refund, most people will be taking out an auto loan to aid their purchase.
The danger of taking out a loan to buy a car is that it’s deceptively easy to get what’s called “upside down” in the loan. An upside down car loan means that you, the borrower, owes more on the loan than the car you’ve purchased is worth.
In fact, depending on how much of your own money you put down at the time of purchase, you may actually drive off the lot already being upside down on your loan.
New Cars Lose Value Quickly
The second you drive off the lot in your new car, your car is no longer “new” from a legal standpoint. Once you leave the lot, your car is considered used, and used cars (no matter how little actual use they’ve seen) cannot be sold as new and are therefore worth less.
How much value does a new car lose after purchase? According to Carfax, new cars lose more than ten percent of their value after the first month of ownership, and more than twenty percent after the first year.
So, if you pay $36,000 for a new car, that means that after one month it’s value is only $32,400. If you put down less than $3,600 at the time of purchase, it means you’re in an upside down car loan. More realistically, because of the interest on your car loan, if your down payment was exactly ten percent you’re probably still upside down.
Why Being Upside Down Is Bad
If you do end up in an upside down car loan, there’s no penalty. There’s no “loan police” that show up at your house and write you a ticket. In fact, you won’t have any problems at all assuming that:
- You don’t try and sell your car
- You don’t have a major accident
- Your income doesn’t significantly decrease
If all those conditions are met, you’ll be fine. However, with the average length of new car loans coming in over five years, it’s very difficult for anyone to safely assume they won’t have any problems during the life of their loan.
If any of those things do end up happening however, you’re likely in for some financial difficulty.
Selling Your Car: If you decide to sell your car (for whatever reason) and you owe more than it’s worth, you’ll have no car but still be paying for it after it’s gone.
Major Accident: If you car is in a major accident and is totaled, your insurance company will only pay the “fair market value” of your car. If you owe more than whatever that amount is, you will again be stuck with no car but still making payments on it.
Loss Of Income: If you lose your job or have to take a paycut, there’s chance you’ll no longer be able to afford your car payments. This means you’ll either have to sell it, or possibly trade it in for a less expensive vehicle. Either way, you’ll still owe money on it after it’s gone.
How Avoid Getting Upside Down
To avoid finding yourself in an upside down car loan, there are a couple principles you should follow before buying a new car:
1) Put At Least 20% Down
The best way to avoid getting upside down is to put as much money as possible into your down payment. You should aim for twenty percent at minimum to avoid going upside down in the first year of the loan. The more you pay upfront, the less you have to borrow, which reduces the risk of your loan getting away from you.
2) Pay It Back Faster
The longer your loan period is, the more likely you are to end up upside down. Don’t sign a car loan with a five or six year repayment plan. Those loans typically have higher interest rates and there’s a greater chance that something will happen in your life that will make repayment more difficult.
If possible, aim for a loan set at no longer than thirty-six months. You’ll most likely get a better interest rate (although your payments will be higher), and both you and your car are less likely to experience major difficulties over a shorter time period.
If you want to avoid ending up in an upside down car loan, buy a car you know you can afford. Be responsible and consider using an affordability calculator or speaking with a financial advisor before making a purchase.
Choose the shortest repayment period that you can, and put as much money down as you can safely afford to.
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