Is there such thing as refinancing a car loan too early? Unless you pay for your new car in cash, you’ll likely take out a car loan. When you do so, know that you don’t have to commit to your initial loan forever. There may come a point where…
You owe more on your auto loan than the value of the car itself. Now what?
That new car smell, fancy leather seats, blind spot cameras… there’s a lot to love about getting a new set of wheels. Except, perhaps, the price tag. According to Kelley Blue Book ‘s most recent data (December 2019), the average price of a new vehicle is $38,948.
If you’ve purchased a new vehicle recently, chances are you took out a loan to pay for it. About 85% of new cars are financed with a loan or lease. Auto loans themselves aren’t a problem — dealerships, banks, and credit unions often offer competitive rates and other incentives, making car payments more affordable.
What can be a problem is depreciation, the reduction in your car’s value over time due to age, wear and tear, and other factors. In fact, in the first 12 months alone, your brand new car loses about 20% of its value.
|How Much Value Do Vehicles Lose Over Time?|
If your car is depreciating faster than you’re paying off the loan on it, you’re putting yourself at risk for being upside down on your auto loan.
Maybe you already are.
How Do I Know If I’m Upside Down on My Car Loan?
When the balance of your auto loan is greater than the value of your car, this is commonly referred to as being “upside down” or “underwater” on your loan.
Step 1: Find out your auto loan balance
Maybe you don’t really know where you currently stand with your car loan. Take a moment to log into your lender’s website or check your most recent statement to see the remaining loan balance. You might be surprised to learn how much you owe.
Step 2: Figure out the value of your car
There are several websites that let you type in your vehicle information to get an approximate value, but the three most common are:
There are several types of valuations for new and used cars: wholesale, retail, trade-in, residual, loan, private party, etc. The two you should look at closely are the retail and trade-in values.
The trade-in value will be lower than the retail value. Most lenders will use the retail value of your vehicle when it comes to auto loans, but it’s best to ask your lender which one they use, just in case. Residual value is also important, but we’ll get to that below.
Step 3: Calculate your LTV
Once you get your remaining loan balance and your car’s value, it’s time to calculate your loan-to-value ratio , aka LTV. Simply divide the loan amount by your car’s value, or use our nifty LTV calculator below.
Car (LTV) Loan-to-Value Calculator
A ratio over 100 means you owe more than the car is worth, which means you’re upside down. The lower your LTV, the better. A high LTV is considered high risk by lenders and can make it harder to qualify for a refinance loan or other loan product.
What Does It Mean to Be Upside Down?
When your car’s value is less than the amount you owe to your lender, you have what is referred to as negative equity. On the flip side, if your car is paid off and in running condition, you likely have positive equity that you can use toward your down payment to trade it in for a new car.
Negative equity happens for several reasons: if you buy a new car without a down payment, roll over an existing auto loan balance into your new loan, have a long loan term, or all of the above. Depending on these factors and the terms of your new loan, you could potentially drive off the lot already upside down.
Why does negative equity matter?
Think of negative equity as an unsecured loan. With auto loans, your vehicle secures the loan. It’s also referred to as the collateral for your car loan. If your lender ever repossessed your car for nonpayment, they could sell it to make up for the loss.
But if you owe more on your new car loan than the vehicle is worth, then it becomes risky. For example, you may owe $7,000 on your car that is only worth $5,000. That remaining $2,000 loan balance doesn’t have any collateral to secure the auto loan. This why upside-down loans scare lenders.
In an ideal world, you’d score a low interest rate when you buy your new car, keep a steady job for the 48 to 72 months as you’re financing it, never get in a wreck, and keep your car running long after the loan is paid off. (Or better yet, you’d pay for your cars with cash.)
But, as we all know, rarely does anything in life go according to plan. Things happen, like:
- Your car gets totaled.
- You lose your job and can’t afford your car payments.
- You outgrow your vehicle (Maybe it’s time for that “Baby on Board” sign).
- You move to a new city where you don’t need a vehicle anymore.
- Gas prices rise, and you now need a more fuel efficient car for your long commute.
- You want a safer vehicle with upgraded features, so you decide to sell.
And the list goes on.
When you’ve got negative equity, you’re still on the hook for the balance of the loan, even if it’s significantly higher than the current car value. So what can you do if you find yourself in one of the above situations?
5 Options When You’re Stuck With an Upside-Down Car Loan
“The decision to act on a negative equity position is really predicated on the urgency of the need. The strategy is different if you have time,” says RateGenius Chief Lending Officer Roger Douville.
You’re probably not going to convince someone to buy your car from you for more than it’s worth. But there are steps you can take in order to get yourself in a better financial situation than you’re currently in. Here are five options to consider.
1. Make extra payments
If you have the money, pay down the loan principal in order to reduce the interest accrued over the life of the loan.
Roger Douville explains, “Most people want to trade their vehicle simply because they have grown tired of the current vehicle or want something different or newer. If the borrower has the ability to do so, making extra payments makes the most sense. If you can pay towards the principal either from savings or a sudden windfall, like a tax refund or bonus from work, that would be ideal.”
Before you start making payments though, check to see if your loan has a prepayment penalty . This fee will wipe out any savings you might’ve earned from paying off the loan balance early.
2. Guaranteed Asset Protection (GAP)
GAP waivers and GAP insurance protect your wallet should your vehicle be deemed a total loss while you still owe money on it.
With a GAP waiver, the remaining loan balance is waived, typically up to 125% of the vehicle’s value — meaning you no longer owe that remaining auto loan balance in the event your car is totaled.
Fortunately, you don’t need to buy a GAP waiver or insurance at the time you purchase your vehicle. Though if you do, you can roll that into your loan instead of paying up front. You can also buy one if you refinance your vehicle (more on that below) or buy one outright from a GAP product provider.
So, if you’re concerned about being stuck with the loan if your financed car is totaled, GAP coverage is definitely worth looking into.
3. Refinance your auto loan to lower your rate
High interest rate on your auto loan? Have you improved your credit score since then? By refinancing your auto loan, you could potentially get a lower interest rate, save money on your monthly payment, and use those savings to pay down your loan.
Much like option #1, you can take advantage of the new refinance offer to pay down the principal on the new loan. “If the consumer has time to plan their exit from the current vehicle,” says Douville, “then I always suggest principal reductions either in a lump sum or in every payment. For example, if your payment is $430 monthly, then pay $450. The $20 will go to the reduction of principal every month, if there are no late fees or past due amounts currently, and may fit better into the person’s budget.”
Keep in mind that if your LTV is too high, you may have a hard time finding a lender that will refinance your auto loan. It becomes more difficult to qualify if you have an LTV ratio over 125. If you have bad credit, the lender may require an LTV under 125, making it even harder to qualify.
4. Trade down
Downsizing your car isn’t ideal, but if it gets you out of a negative equity situation — or greatly reduces it — it may be worth considering.
Used cars today are very reliable. Today, the average lifespan of a vehicle is 12 years, and you can expect to get 200,000 miles or more on a passenger vehicle.
Trading in your upside-down car for an affordable, used car save you money every month while also giving you the chance to pay down the negative equity that was rolled over.
5. Trade in for a vehicle with MSRP incentives
You’ve seen the commercials: $10,000 off MSRP for a new vehicle. Those dealer promotions that knock off thousands off MSRP may be enough to offset the negative equity on your upside-down car loan.
Manufacturer Suggested Retail Price, aka sticker price, is the auto manufacturer’s recommended selling price on a new vehicle. Dealers use these promotions to offer cash discounts and lower the selling price to entice buyers.
If you do go this route, beware of dealership sales tactics… promises of lower monthly payments, expensive extras, etc. You don’t want to end up in another bad financial situation (i.e. upside down again) due to clever upselling.
Can I Trade In a Car With Negative Equity?
You may be considering trading in the vehicle and making arrangements to pay off the remaining balance. It’s certainly a possibility.
If your household can manage downsizing to one vehicle, you can then make arrangements to pay off the negative equity while saving for a down payment for your next new car. This is an especially practical option if you live in a city with reliable public transit. Unfortunately, this isn’t always the case.
So what can you do if you can’t trade in or sell your car? You can try a balloon loan.
What’s a balloon loan?
“Balloon lending is not for everyone,” says Douville. “If you are in a hurry to get out of your current auto, then this isn’t for you, but if you want out of your negative equity position it might just be the thing that could help.”
Balloon loans work a lot like a lease:
- The lender calculates the residential value of your vehicle for a time period, typically 36 months, and calculates the repayment schedule based on that amount.
- The borrower (you) pays a lower monthly payment throughout the balloon loan period while still maintaining ownership of the car. This means you could still technically sell the car or trade it in.
- When the balloon loan period ends, you have two options:
- You can walk away from the vehicle. The lender then liquidates it (sells the vehicle), and you no longer have a balance to pay.
- Or, you can choose to pay the lump sum balloon payment (the upside-down principal balance) to keep the car.
You’ll still have negative equity on your vehicle during the balloon period, but it’ll no longer be your obligation if you choose to turn it in to the lender. However, if you decide to keep the car, you’ll be required to pay a large lump sum payment. Your lender will calculate this amount based on a percentage of your car’s MSRP.
Should I Take out Another Type of Loan to Pay off My Car Loan?
Let’s say you’re in a real financial bind and need to take immediate action to keep your car. Taking out another type of loan — like a personal loan, credit card, or home equity line of credit (HELOC) — to pay off your car might be tempting, but it can have negative consequences.
“Trade-in is always a better option than debt,” advises Douville. “Acquiring debt to pay down negative equity is not the best option unless the vehicle is unsafe to drive.”
If you’re behind on your loan payments, piling on more debt may only make the problem worse. You risk not only losing your vehicle, but also ruining your credit and defaulting on the other loans. And defaulting on your HELOC can lead to foreclosure of your home.
Getting Your Car Loan Right-Side Up
Being upside down on your auto loan isn’t always the easiest situation to get out of, but it certainly is possible. With a little research and a plan, you can take the necessary steps to not only keep your car, but also save your credit and bank account.