What Does an Underwater Car Loan Mean?
Many people choose to finance their car purchase with a loan, which means they make monthly payments until the loan is paid off. However, if the value of the car decreases faster than the loan is being paid off, the borrower may end up “underwater” on the loan. In other words, they will owe more money to the lender than the car is actually worth.
Being “underwater” on your car loan is also known as being “upside down“. Both of these phrases refer to having a vehicle with negative equity.
What Makes a Car Loan Become Underwater?
Depreciation is the primary reason why a car’s value can decrease over time, and while depreciation is a natural process, it can sometimes be accelerated by factors such as poor maintenance or accidents.
Another reason why a car loan may become underwater is if the borrower makes a small down payment when they purchase the vehicle. This leaves them with a high loan balance relative to the car’s value, making it more likely that they will owe more than the car is worth in the future.
Loans with longer terms also tend to have higher balances at any given point in time, which also increases the chances of an underwater loan.
In general, borrowers should be aware of these risks when taking out a car loan and make sure that they are comfortable with the possibility of their loan becoming underwater.
How to Avoid Going Underwater
With so many options to choose from and so many numbers to consider when in the car buying process, it’s easy to want to rush into a decision. There are certain considerations to keep top of mind during this process so you can ensure that you don’t end up “underwater” on your loan. While there are a number of factors with limited control that can contribute to this situation, there are some steps you can take to avoid it.
It’s important to be realistic about the value of the car you’re interested in. Just because a vehicle has a high sticker price doesn’t mean that it will hold its value over time. In fact, new cars will experience accelerated depreciation in the beginning of a loan in comparison to used cars. Do your research and look at historical data to get a better sense of how well the car you’re considering is likely to retain its value.
You should also take your own budget into consideration when making your decision. It’s important to remember that a car is a long-term investment, and you’ll be making payments on it for years to come. Make sure you can comfortably afford the monthly payment, as well as any additional costs such as insurance, gas, and maintenance.
It’s also important to consider the length of the loan when making your decision. In terms of a vehicle’s equity, shorter loans are better than longer ones, as they will have lower balances and therefore be less likely to become underwater. If you can’t afford the monthly payments on a shorter loan, however, it may be worth considering a longer loan and/or a larger down payment.
Know Your Options if Your Car Loan is Underwater
There are a few things that can happen if a borrower finds themselves underwater on their car loan.
If you need to sell or trade in the car before the loan is paid off, you may have to pay out of pocket to cover the difference between the car’s value and what is still owed on the loan.
Alternatively, you could keep making payments until the loan is paid off and then sell or trade in the car, but this would mean paying more than what the car is actually worth. Some borrowers may be able to refinance their auto loan if their credit score has improved since taking out the original loan, but this will not be an option for everyone.
If you are thinking about taking out a car loan, it is important to be aware of the risks of being underwater on the loan. Make sure you research how quickly different types of cars depreciate and factor this into your decision.