What to Do When You’re Upside-Down on a Car Loan

Auto Loans, Loans
what-do

When you owe more than your vehicle is worth, you are upside-down, or underwater, on your car loan. This doesn’t immediately spell trouble, but it can result in less financial flexibility and security.

You face two major risks: If you get into an accident, your insurance will generally cover the damage only up to the value of the car — not how much you owe — and, if your situation changes and you need to sell your car, you’ll do so at a loss. The difference between the car’s value and the loan amount is your negative equity.

Best options if you’re upside-down

‘Drive through’ the loan

If you can, the best move is to simply keep your car and finish the payments until you either own it outright or you’re back to owing what the car is worth (or less).

If you’re concerned about insurance coverage in the meantime, you can purchase gap insurance, which covers the difference between the value of a car and what you owe on the vehicle in the event that it’s totaled. Once you’re no longer upside-down, cancel your gap insurance so you aren’t paying for more coverage than you need.

Avoid an upside-down car loan

1. Don’t overpay. Bogus fees, seductive extras and savvy dealers make it easy to overpay for a car. Paying $35,000 for a car worth $29,000 starts your loan upside-down.

See NerdWallet’s guide on getting a good deal, and use online pricing guides like Kelley Blue Book or Edmunds to determine how much you should pay for your car.

2. Look out for long loans. Long terms, like 72- and 84-month auto loans, are appealing because they offer low monthly payments. But cars depreciate quickly, so you’ll be making the same payments even as your car’s value drops significantly. You’ll also pay interest for a lot longer, too.

NerdWallet recommends getting a new car loan for no longer than 60 months. Used cars should be financed for about 36 months.

3. Be wary of no-money-down deals. For those low on cash, putting $0 down is an attractive option. However, the more you put down, the less you have to pay interest on and the more you can get ahead of depreciation. With no money down, you will immediately be upside-down.

NerdWallet recommends paying as close to 20% as possible upfront for new cars. This is approximately how much your new car will depreciate in the first year.

Pay more now

Remember: Lenders don’t want you to default. It’s worth talking to them about your situation. Check your lender’s rules to see if you might be able to make extra payments toward your principal. This will mean you’re paying down your loan more quickly so you can catch up with depreciation.

Refinance with a shorter term

Refinancing won’t lower your loan amount and it won’t automatically eliminate negative equity. However, if you shorten the term — and, thus, increase your monthly payment — it can help you reach positive equity more quickly. And if you qualify for a lower rate, you save money over the life of the loan.

Whether you’ll qualify to refinance depends on factors like your credit profile, payment history and the ratio of your loan amount to the value of your car. Lenders have different credit requirements, as well as varying cutoffs for loan-to-value ratios, allowing loans ranging from 110% to 140% of a car’s value, says Ashley Misner, director of marketing for Autopay, an online auto loan marketplace.

So if you are able to refinance, get the shortest term you can manage, but remember this will boost your monthly payment. Use an auto loan refinance calculator to estimate your potential savings.

If you have to sell

If you sell your car and pay down your loan with the proceeds, you’ll still owe the remaining balance on the loan and you’ll have no car. Make sure you can find other transportation for work and family matters before considering this option. If possible, sell your car to a private buyer, which tends to draw a higher price than trading it in at the dealership. With a good sale price, you may have a more manageable amount of debt.

Tread carefully with trade-ins

If you decide to trade in your car, be aware that this doesn’t eliminate negative equity — it rolls it into the monthly payment on your new loan. This means you could end up taking on even more debt. “What’s more likely is you’re going to end up just constantly rolling over negative equity,” says Chris Kukla, executive vice president of the Center for Responsible Lending.

However, if you do the math carefully, you can make a smart move. Look for cars with cash-back rebates that can help you break as close to even as possible. So if you’re $3,000 upside-down, but you find a car with a $3,000 cash-back offer, you balance out your negative equity.

But be aware that incentivized cars may depreciate faster, “so you may still find yourself underwater anyway,” warns Kukla. Most importantly, search for a less expensive, used vehicle and keep your loan term no longer than 60 months.

Problem debt

It’s frustrating to know that you owe more than your car is worth. Remember that you can simply “drive through” it. However, if your car loan is turning into problem debt, you may need to take a closer look at your finances. Consider finding ways to make fast cash or working with a credit counselor. And, if you’re worried about missing car payments, check out NerdWallet’s guide to avoiding repossession.

Nicole Arata is a staff writer at NerdWallet, a personal finance website. Email: narata@nerdwallet.com.