Upside Down Car Loans

When you are upside down, your head starts fill with blood, you get disoriented, and find it difficult to breath.  When you are in an upside down car loan, it’s just about the same feeling.  Finances don’t like upside down loans; they are simply uncomfortable states of being.  You might be asking what an upside down car loan is.  Plainly speaking, it is a car loan that is worth more or has a greater balance than the car it paid for. 

That Sounds Crazy, How Does Someone Let That Happen?

Basically, almost all car loans are upside down for a little while.  A vehicle’s value depreciates considerably as soon as you drive it off the lot.  A car you paid $40,000 for may only be worth $20,000 in three years.  Of course, your car loan might only be paid down to $30,000 by that point, so you end up with an upside down loan. 

While it is an uncomfortable feeling to have an upside down loan, it’s not exactly uncommon.  Think about it.  Most car loans are structured in such a way that the depreciation curve for the car’s value is greater than the amortization curve for the car loan, but they do eventually intersect and you can build equity in a car.  The trick to building equity in the car before it depreciates too far is to pay off as much of the car loan as possible as quickly as possible. 

Lower Payments = Less Equity

Anybody who has ever had any kind of loan knows that when you lengthen the terms of your loan, you lower your payments and increase the amount of total money you pay for whatever it is you got the loan for in the first place.  Because the value of the car is less than the car loan and the car loan payments don’t change, an upside down car loan will not affect your credit.  Although it could affect what kind of auto loan interest rate you may get on your next auto loan if you trade this existing car in early.  This is mostly based on the assumption that when you trade in an upside car loan, you are not trading in anything of value.  You will, in fact, be adding to the balance of the car loan on the new purchase with the remainder of what is left on your existing car loan after the trade in value, assuming you don’t provide a large down payment for the new car loan.  It had become fairly common to see more car buyers purchase cars more frequently and each time they trade ion the car that has a loan upside down, they are increasing the balances of their new loans and incurring quite a financial burden with the large monthly car payment.

Long term auto financing isn’t always bad.  It can make sense for someone who plans on keeping their car for quite some time.  With modern cars being built increasingly well, this is a viable option for more and more people every year.  Lower payments of course makes a car easier to afford, and if you can set up your loan to match your goals as far as how long you’re going to keep your car, you can come out ahead. 

Long term auto financing doesn’t make sense if you plan on buying a car every two to three years.  Setting up a long term loan could very well mean that you haven’t crossed that threshold where you gain equity before you trade it in.  In other words, you won’t get enough on your trade in to pay off your loan. 

The Benefits of Leasing

Some people simply like to drive newer vehicles.  There is nothing overtly wrong with this, but it does make it tricky to purchase vehicles.  Unless you can afford to pay cash, you’ll most certainly have an upside down car loan every time you trade in.  One good option for this type of consumer is the option to lease a car. 

In a lease, you essentially rent a car for three years or so.  The financing company then takes over responsibility for the car’s value after the term of the lease is up.  After those two to three years, you trade it in for a new car, along with similar terms.  The availability of similar lease terms has become an issued as of recent, unfortunately.  Lease terms have become onerous with a tighter credit market.

If you are a high mileage driver, you may not want to lease a car.  Many lease agreements have mileage restrictions and hefty fees associated with going over those allowable miles.  Other stipulations may include usage restrictions.  A truck designed for road use for example, may technically go off road, but it may void or activate certain clauses in your agreement.  You also will most likely not be allowed to add aftermarket upgrades to the car.

Since leases are dependent on the finance companies assessment of the cars future value and car values have not held up particularly well in recent years, lease terms are becoming more onerous.  There are more restrictions and the monthly payments have risen significantly.  A good car purchase with a good car loan is generally the better long term option.

Minimizing Your Exposure to Risk

Structuring your loan to include a larger down payment and smaller monthly payments is the best way to help avoid an upside down car loan.  With smaller payments, you can afford the loan better, thus allowing plenty of room in your budget to overpay the payments or make additional amounts of payments on the auto loan.  If you put just $20 or $30 extra into each payment, you can shorten the life of the auto loan by a year or more depending on the terms.
 
Using your good credit to help someone else get a car isn’t a good idea, and often leads to bad car loans.  Cosigning is more popular than ever before, but be aware that if the primary buyer defaults, you are responsible for the payments.  And even if the cosigner is merely late on their monthly car loan payments, this will often be reflected on your credit report as you have guaranteed the payments by cosigning the car loan, the payment record is part of your credit profile.  Next time the cosigner applies for a new car loan that poor payment record is going to mean a higher interest rate and larger down payment.

A large down payment on a new auto loan is essential, no matter what route you go, as it will lower the amount of money you have to finance, and thus the amount of the individual payments.  Taking the special offers advertised by car dealerships is often a good way to apply the rebates to an auto loan that is coming directly from a bank.  The dealer rebates with a low rate auto loan will most certainly lower your payments.  Anything the dealer offers you to help lower the amount financed with the car loan is a good thing.

Tags: auto finance, auto loans, car loan rates, car loans

This entry was posted on Friday, February 27th, 2009 at 7:21 am and is filed under Articles. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.