What to Do When You Owe More on Your Car Than It’s Worth

What You Should Know About Your Negative Equity Car Loan

under water

First, a simple definition: a negative equity car loan—also referred to as being “upside down” or “underwater” on a loan—means you owe more on a vehicle than it’s worth, and it’s a more common scenario than you might think.

From the J.D. Power Automotive Forum on March 22: Nearly one third (31.4%) of car owners currently have a negative equity car loan. Even more concerning: “The percentage of car owners facing negative equity is expected to hit a 10-year high in 2016,” USA Today reports.

How do people get into a negative equity situation with cars? For one, brand new cars lose an average of 11 percent of their value the minute they’re driven off the lot. So say you take out a loan for $25,000 on a new car valued for the same amount. Just a few minutes after you drive off the lot, your car may only be worth $20,000, meaning you now owe $5,000 more than the car is worth.

Having negative equity isn’t always terrible, but it can mean added expense if you’re looking to sell or trade in your vehicle, and it can cause you a lot of grief in the event of a wreck or a theft. Let’s explore what to do if you find yourself with a negative equity car loan, and how to get out from underwater.  

black BMW driving on wooded road

What a Negative Equity Car Loan Means for You

Barring extenuating financial circumstances (like missed payments), having a negative equity car loan usually just means you’ve purchased a car that’s depreciated faster than you’ve made payments and you need time to catch up. Cars—especially new ones—depreciate a lot in the first few years (20-30%), and then depreciation tends to level off, writes Edmunds. If you have no plans to sell or trade in your vehicle, your situation is tenable.

But, if you’re trying to purchase a new car with a new loan and want to trade in or sell your current car, a negative equity loan will be a complication (read: added expense): you’ll either have to roll over the negative equity into your new loan or pay it off (and if you could do that, you probably wouldn’t be underwater in the first place). Purchasing a new car while underwater on your current one is a choice, of course, and individual buyers will have to weigh their options to decide if they want to take on the added financial burden.

Some situations you may find yourself in while underwater on a loan can be quite expensive. Getting into a car wreck that results in a total loss, or having your car stolen while underwater on a loan, can mean that not only will you not be compensated for vehicle replacement, you might actually owe your lender money. Using our previous example of the $25,000 car: if you’ve only paid off $2,000 of the vehicle (through either down payment or loan payments), and the vehicle is determined to be worth just $20,000 at the time of a total loss, you’ll owe your lender $3,000. Not a fun situation to find yourself in, to be sure, but GAP insurance can offer protection (details below).

A negative equity car loan may mean you bought a car that depreciated faster than you made payments.

Ways to Get Out From Underwater:

  • Make larger monthly car payments (as your budget allows).
  • Keep the car you’ve got until you’re above water (that is, until the car is worth more than you owe).
  • Roll the negative balance into your new car loan—this costs you nothing out of pocket, but be aware that you’ll likely be making higher monthly payments and you’ll still have to pay off the negative balance.

If you’re really underwater on a bad loan (the interest payments are quite high) or you’ve missed payments, and your monthly bill is high but you still won’t pay off the loan for a long time, selling the car and taking the financial hit might be your best bet in the long run, but be sure to carefully calculate expenses and get help from a financial advisor if you can. Refinancing your loan is another option, but be sure to use a reputable lender.

credit card and laptop

Be Wary of Certain Types of Loans

One of the best ways to avoid a negative equity auto loan in the first place is to make a large enough down payment. Edmunds offers car buyers some great advice about how to determine an appropriate down payment and make sure you’re buying a car you can actually afford. 

Be wary of loans with little to no down payment and extended loan lengths (like those reaching 84 months), Michael Harley, chief analyst at Auto Web, explained. If loans like these are all you qualify for, or all you can afford, there’s a very good chance you shouldn’t be spending so much on the vehicle and should instead consider less expensive options.

One of the best ways to avoid a negative equity auto loan is to make a large enough down payment.

Some solid loan advice:

  • Your car payment should not be more than 20 percent of your take-home pay.
  • Finance cars for no more than five years.
  • Try to put 20 percent down.
  • Finance used cars for three years with about 10 percent down.
  • More financing tips—for both new and used cars—can be found here.

GAP Insurance: How it Can Help

If you have negative equity, for whatever reason, GAP (guaranteed auto protection) insurance might be a good choice. GAP insurance is a smart choice for anyone paying less than 20 percent down on a new car, and anyone rolling over a negative equity loan. This way, if you experience a total loss or a stolen car while you have negative equity on your loan, you’ll be covered.

Keep in mind: GAP insurance doesn’t cover negative equity in the event that you want to replace your current vehicle with a different one—if you’re underwater in that case, you’ll have to make up the difference with either cash or an even bigger new car loan.

The bottom line: If you have negative equity on a car loan and you can afford the payments and have an end in sight, the best thing to do is to ride it out–keep making payments and put off trading in or upgrading your car until you’re in a more secure financial position.

Originally contributed to Credit.com.