Is Your Car Loan Upside Down?
by admin on Dec.15, 2008, under Car Tips
Is Your Car Loan Upside Down?
A lot of people have heard about homeowners going “upside down” in their mortgages. They don’t realize that it can happen with car loans just as easily. In fact, because houses tend to appreciate in value over time while the value of your car tends to go south, it’s more prevalent with auto financing. In essence, it means that the amount of money you owe is greater than the value of your vehicle. Today, I’ll explain how it happens. I’ll also provide a few tips that will help you avoid going upside down in your next car loan.
How Auto Financing Goes Awry
To illustrate how your auto financing can go upside down, I’ll use a hypothetical example. Let’s say you’re buying an SUV and it costs $40,000. You put a down payment on it of $5,000 and carry the rest ($35,000) on a 5-year term. After 3 years, you’re tired of driving your SUV and want to sell it. Unfortunately, it’s only worth $20,000, despite your owe $24,000 on the financing. You are officially upside down. That means if you want to sell the SUV, you’re going to have to come up with another $4,000.
If it’s any consolation, this happens to a lot of people. It’s due to your vehicle’s depreciation.
The Impact Of Depreciation
You probably already know that most vehicles lose about half of their value through depreciation over the first 3 years. Now, keep in mind that the amortization of your loan happens for the entire life of the term (5 years in our example). The problem is that your SUV depreciates at a quicker pace than the amortization over the first 36 months. After those 3 years pass, the depreciation slows down. That allows the amortization to “catch up,” bringing your financing back into a “positive equity” position.
How To Avoid Taking A Bath
First, realize that carrying an auto loan with negative equity (in other words, owing more than the car is worth) won’t have any effect on your credit. So, that shouldn’t be a concern. Second, understand that the longer you stretch out the period over which you finance your vehicle, the longer it’ll take for the amortization to catch up with the rate of depreciation. That means you’ll be in the negative position longer with a 5-year term than you will with a 4-year term.
To avoid getting caught owing more than your vehicle is worth, put a larger down payment on it. Then, plan to keep driving it through the entire term instead of immediately selling after 3 years. Remember, the depreciation is what turns the loan upside down. If you’re absolutely sure you’re going to sell your car before you’ve paid off the financing, shorten the term to 4 years.