As new car models for next year start showing up on dealer lots, people will be hurrying to get the latest deals and car features. Many of these people may still be paying on their current vehicles. Yet the lure of dealer incentives, affordable loan payments and low interest rates will cause many of them to say goodbye to their old cars and say hello to their brand new models. Unfortunately, this scenario can lead to people being underwater on their auto loans.
What is an Underwater Loan?
Sometimes you will hear the words “underwater” and “upside down” when referring to auto loans. Technically, these terms refer to a time period where the loan amount you owe on something is actually more than what that item is worth. It can refer to both auto loans as well as home mortgages. In this instance, we’ll be focusing on car loans as an example.
Let’s say you purchase a new vehicle for $25,000. Unlike houses that typically appreciate in value, cars depreciate the moment you drive it from the dealership parking lot and will continue to lose value every year. A $25,000 car can depreciate around 10 percent (in this example, $2,500) the moment you get it home from a dealership.
So you are paying $25,000 for an auto loan on a car that now has a value of $22,500. This example means that you are upside down, or underwater, with your loan by $2,500, which is called negative equity ($25,000 – $22,500 = 2,500). If you decide to sell the car for its current value of $22,500, you will still owe the lender the negative equity amount of $2,500.
How People Become Underwater on a Loan
People can find themselves underwater on their loans by a significant amount due to the following circumstances:
- Not placing a large enough down payment on the car to lower the owed loan amount
- Extending the car loan term causing them to pay more interest over a longer period of time
- Making minimal payments or missing monthly payments
- Continually rolling an old loan into a new loan
This circumstance can have a snowball effect if you are the type of person who is constantly purchasing a new car without completely paying off the previous loan.
Keeping Your Finances Above Water
Perhaps the best tip is to keep your existing car until the loan is paid off. Then you can sell it without any worries of carrying negative equity. Depending on your lender and loan agreement, you can usually make higher monthly payments and put the extra funds directly towards your loan principal. This will help lower the amount you owe on your loan and enable you to pay the loan off quicker.
If you are paying high-interest on the loan from another lender, you should consider refinancing the loan with the credit union. This will help you save on interest as well as obtain a more favorable loan term to prevent you from being underwater.
We’re Here to Help!
Before you go car shopping, stop by or give us a call at 800.782.4899 and ask about your current loan balance and NADA value. This will help you understand if you are underwater on your loan or if you have extra equity in your vehicle.
Each individual’s financial situation is unique and readers are encouraged to contact the Credit Union when seeking financial advice on the products and services discussed. This article is for educational purposes only; the authors assume no legal responsibility for the completeness or accuracy of the contents.