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When you're upside down on your car loan, it means that you owe more than the vehicle is worth. This may also be called negative equity or being underwater. According to the most recent data available from Edmunds, 44% of new car sales in April 2020 involved a trade-in with negative equity.
If you're underwater on your car loan, it could result in a deficiency balance if the vehicle gets totaled. And if you trade it in for a new car, it could cause you to have negative equity on the new car, making your situation worse. Fortunately, there are a few steps you can take to alleviate the problem.
1. Consider Getting Gap Insurance
Gap insurance helps cover the gap between your vehicle's value and the outstanding balance on your loan in the event your vehicle is stolen or totaled in an accident.
Without gap insurance, your lender will typically require you to pay the difference. But if you have gap coverage, you can file a claim to have that provider pay off the deficiency amount.
Keep in mind, though, that gap coverage can come with several limitations and exclusions, so be sure to review the fine print carefully before buying a policy.
2. Pay Down Your Loan Faster
If you can afford it, consider accelerating your car loan payments. Even if you can only put a little more than your monthly payment toward the loan, that extra amount can directly pay down the principal balance instead of going toward interest.
You may also consider cutting back on some of your discretionary spending, earning more income or using tax refunds, a performance bonus at work or other small windfalls to pay down your loan.
3. Keep Your Car For Longer
While this might not help you if your car gets totaled in an accident, it could help you avoid making the problem worse by trading in the vehicle when buying a new car. Remember, too, that depreciation typically slows down over time, so the longer you hold onto the vehicle, the better your chances of catching up with depreciation with your loan payments.
Unless you absolutely need a new car, consider driving your current one around longer while you pay down your loan balance.
4. Consider Refinancing the Loan
If your credit score wasn't in the best shape when you first took out the loan, a good chunk of your monthly payments may be going toward interest charges. If your credit has improved since then, you may consider refinancing the loan to obtain a lower interest rate. Then, you can continue to send the original loan payment amount to the lender and pay off the debt faster.
Switching to a shorter repayment period is another way to pay down the loan faster. Just make sure you can afford the new, higher monthly payment.
5. Sell the Car to a Private Buyer
If you can't escape the need for a new vehicle, you'll generally get less money if you trade it in compared to selling it in a private-party transaction. This process takes more time and effort, but it could net you hundreds or even thousands of dollars more than a trade-in.
Even if that's not enough to wipe out your deficiency, it could save you some money in the long run.
How to Avoid an Upside-Down Car Loan
An underwater car loan can impact your financial well-being, so it's important to try to avoid negative equity as much as possible. Here are some potential ways you can do so:
- Make a larger down payment when you first buy the vehicle.
- Request a shorter repayment term.
- Research vehicles based on how well they hold their value.
- Avoid add-ons at the dealership, such as maintenance packages and extra features that add to the loan balance.
- Buy used or certified pre-owned vehicles instead of new vehicles to avoid a significant drop in value during the first year.
Build Your Credit to Maximize Car Loan Savings
Whether or not you're upside down on your car loan, your interest rate is one of the most important features of your car loan. If your credit is in poor shape, interest rates can climb upwards of 20%, making monthly payments difficult to afford. What's more, it's more likely that you'll end up underwater because so much of your monthly payments is going toward interest charges.
So, whether you're planning to buy a new car or you're trying to figure out what to do with your current one, your best bet to maximize savings is to improve your credit score. With Experian's free credit monitoring service, you can get access to your credit score and your Experian credit report, allowing you to see where you stand and determine which areas you can address to improve your creditworthiness.
You can also track your progress and see how your actions influence your score. This process can take time, but when you're ready, you can apply for an auto loan or a refinance loan with better chances of securing a favorable interest rate.