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

A dirty backseat

Dirty vehicle | Source: YouTube/SuperiorShine

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.

Nearly one-third (31.4%) of car owners currently have a negative equity car loan, according to a J.D. Power Automotive forum in March 2016. And USA Today reported something even more concerning: “The percentage of car owners facing negative equity is expected to hit a 10-year high in 2016.”

How do people get into a negative equity situation with cars? For one, brand new cars lose an average of 11% 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 expenses 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 you can do if you find yourself with a negative equity car loan, and things that may help you get out from underwater.

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 value depreciated faster than you’ve made payments and you need time to catch up. Cars — especially new ones — depreciate a lot (20-30%) in the first few years, and then depreciation tends to level off, according to 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, 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 this is a time where guaranteed auto protection (GAP) insurance can be helpful.

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 (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 something to consider. 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.

Be wary of certain types of loans

One of the best ways to help you avoid a negative equity auto loan in the first place is to make a large enough down payment. This is why it may be helpful to determine an appropriate down payment before going car shopping and make sure you’re buying a car you can actually afford. (To give you an idea of whether you might qualify for the best rates on your car purchase, take a look at your free credit report summary on Credit.com.)

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, you may want to consider less expensive options.

Some loan advice to consider:

  • Try to keep car payments less than 20% of your take-home pay.
  • Aim to finance cars for no more than five years.
  • Try to put 20% down.
  • If you’re getting a used car, it may be better to finance it for three years with about 10% 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 insurance might be a good choice. GAP insurance may be a good option if you’re paying less than 20% down on a new car or 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 have coverage.

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 may simply be 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.

More from Credit.com

This article originally appeared on Credit.com.