The economics of buying a car is driving many households into a financial pothole where the value of their car is less than the remaining balance on their car loan.
Nearly 33% of car buyers last year traded in a car that was worth less than the remaining loan balance, according to Edmunds.com, owing on average more than $5,000 on their old loan.
In 2012, less than one in five trade-ins involved buyers who were upside down on their existing car loan, the industry term for borrowers whose asset (the car they are trading in) is worth less than their debt (the remaining loan balance.)
What's Fueling the Uptick in Upside-Down Car Loans?
Car prices increasing faster than household incomes has pushed the average new car loan above $30,000 according to Experian's most recent State of the Automotive Finance Report. At today's prices, the cash down payment borrowers make is often not enough cushion to offset the decline in value of a car. A new car typically loses about 20% of its value in the first year (and more in subsequent years) almost twice as much as the average down payment these days, according to Edmunds.
Meanwhile, to make monthly payments more affordable, many borrowers are choosing long loans. While 72-months remains the most common loan term—and now represents nearly 24% of the market vs. just over 10% in 2008—more new loans have spilled into the 85-to 96-month length, according to Experian. The longer you take to pay back a loan, the longer it takes to build up equity.
You can get a quick estimate of whether you are upside down by checking Kelly Blue Book for the estimated value of your car, and compare it to the remaining balance on your car loan.
What to Consider If You Are Upside down on a Car Loan
1. Protect Yourself with Gap Insurance Coverage
If your car is totaled in an accident or stolen, your standard comprehensive and collision insurance coverage will pay you the current market value of the car, minus any deductible. But the insurer doesn't care if the check it writes you isn't enough to pay off your loan.
Adding GAP insurance (Guaranteed Auto Protection) to your basic coverage will entitle you to a payout that also covers the difference if your car's market value is lower than your remaining loan balance. According to the Insurance Information Institute, GAP coverage typically adds about $20 or so to the annual auto insurance premium.
2. Pay Down Your Loan Faster
One way to get out of being upside down is to accelerate your car loan payments. If you've got some extra cash-flow—from a raise or bonus at work, or a hefty tax refund, for example—consider using a portion to make extra principal payments on your auto loan. Or trim your monthly spending so you can free up some extra money to earmark for your car loan.
3. Drive Your Car Longer
A common workaround is to roll the remaining balance on your old car loan into the loan for the new car. That can be a costly decision, as it effectively increases the cost of your new car. Holding on to a car with an upside-down loan can be a smart financial move as it will keep you from rolling the debt into a new loan, and give you more time to pay down the loan.
4. Shop for a Car with a Big Cash Rebate
If you decide you want to trade in your upside-down car, shop for cars with promotional offers for big cash rebates. You can use that cash to pay off the loan on the car you're trading in.
How to Steer Clear of Ever Being Upside Down on a Car Loan
When shopping for your next car, there are ways to minimize the chance you will find yourself upside down on your auto loan. A down payment of at least 20% makes it more likely that your loan balance will not exceed the depreciated market value of your car. Shopping for a less expensive car can make your down payment dollars go further.
For instance, a $5,000 down payment is less than 15% of the purchase price of a $35,000 new car, but it's 25% of a $20,000 loan for a less-expensive new car, or a used car. Or you can spend some months setting aside money in a bank or credit union account to plump up the cash you will be able to put toward the down payment on your next car.