How Not to Get Upside Down on Your Auto Loan
In 2011 I bought a lemon. I won’t tell you the car, as some of my friends own the same make and model from the same dealership and have had no complaints whatsoever. It’s entirely possible that I was just unlucky, and happened to leave that day with a car that simply slipped through the cracks at the factory.
Say it’s summertime and you’re at Walmart (this happened to me too). You see a 12-foot above ground pool on display. It’s hot; you think your kids will love it so you decide to get it for your patio, which you estimate from memory should be able to accommodate your new plastic lagoon. When you get home you smartly decide to measure the patio before unboxing the pool and realize to your dismay, that it will not fit.
You take the unopened box back to the store and the good folks at Walmart refund all your money immediately and without hesitation.
In 2011, nary a week after leaving the dealership, my brand new car started to heave and sputter on a mountain road, which really wasn’t even that steep. The week after that the engine started to overheat in traffic, blowing hot air out of the AC.
Now it would seem entirely fair that the dealership, like Walmart, would realize I’d bought the wrong product and, immediately and without hesitation, provide me with a new car to replace the faulty one.
Of course you know that didn’t happen. We all know that once you drive that baby off the lot it can depreciate up to 11%. So my car, which cost in the neighborhood of $28K, was worth $24,920 before I got home and before one payment was made.
Getting Upside Down
Basically being upside down means you still owe more on the loan than the car is currently worth.
An auto loan is like any other loan. As explained here when you first start paying off a loan the majority on your monthly payment goes toward interest. As time goes on and the principal (loan amount) reduces, the interest becomes less and more and more of the payment is applied to the loan. In the final year of the loan you are aggressively paying down the principal and the interest is small.
Since the car is valued at up to 11% less than the original loan when you drive off the lot, you are already technically upside down on day one! But the good news is if you’ve gotten a good APR, kept the car in good condition, and chosen a shorter loan term, you’ll have paid down the loan under the car’s value and created equity within the first year.
So how do people get upside down?
There are two scenarios. Firstly, if the car is totaled or stolen early into the loan, before you’ve paid it down sufficiently. In this situation you’re going to be upside down regardless of your APR or term. This is what GAP insurance is for.
The second scenario is what happened to me. I decided to go with an over long loan term to keep the monthly payments down. Long loan terms aren’t a good idea as interest rates are usually higher and you’ll be paying MORE interest period due to the longer time frame. If you’re taking this kind of deal you might want to ask yourself, as I should have, “am I buying a car I cannot afford?”
Four years into this loan, because I’d stretched the payments out so far I’d not paid down enough of the principal. Combine this with the fact that because the car was a lemon, and because of this I wasn’t as eager as I should have been to fix dents, dings, and scratches, it was appraised for much less than it should have been worth if everything was working properly.
The car was worth about $6,500 and I owed $11,000. After FOUR YEARS I was still upside down. Fortunately (if you can call it that) I found an eager dealer who appraised it at a little higher and absorbed the old loan into the new one.
So now I’m driving around a brand new functioning car, but kind of on the hook for the old one. I’m paying the price past mistakes in the form of a much higher monthly payment than I should have.
Getting Right Side Up
First and foremost, if you’ve purchased a lemon like me familiarize yourself with your state’s lemon law. You have recourse to the law and may be entitled to a replacement vehicle or refund.
Secondly choosing a shorter loan term and/or making a solid down payment, in conjunction with properly maintaining your vehicle will get you right side up and building equity in your car much faster. So if your car gets stolen, or you want to sell early, there will be no problem. The value of the car will exceed what you owe and you won’t be stuck upside down.
And if you’re at a dealership getting talked into a long term so you can afford the monthly payments, remember they’re not doing you any favors by getting monthly the payment down. They are just trying to get the car out the door. As I said above, it’s smarter to go with something cheaper with a shorter term.
With our advertising partner LendingTree, you can exercise negotiating power and not be at the mercy of whatever the dealership has to offer. You get the flexibility of being able to compare the best rates and offers from competing lenders. Just enter the vehicle and loan term information and you’ll have an offer to take to the seller in minutes.