Having an upside-down car loan can be a nightmare. Learn what it means to be upside-down on your car and what you can do about it.
Americans and their Cars
Americans have a love affair with their cars. We spend a huge chunk of our income to buy them. For most of us, they are the most expensive thing we buy that decreases in value. And, we are willing to leverage our future to get them.
The median household income in the US is about $60k, which results in a monthly take home pay of about $4,000. The average car loan in the US is approaching $600 per month. To “help” people afford more and more expensive cars, lenders are offering longer loan repayment periods. I’m starting to see car loans with 7-year repayments! This is insanity. A $600 monthly payment over 7 years could be as much as a $50,000 loan!
I really try to keep this a no-judgement zone. But, if you financed more than your annual take-home pay on a car, that was a bad decision. I won’t judge you if you paid cash for your fancy car. But, if you financed… I’m sorry, that was not smart.
The reason it is not smart to borrow so much for a car purchase is because the car decreases in value. Fast.
And, if you are not paying down the loan faster than the car is decreasing in value, then you will quickly owe more on the car than it’s worth. And, that’s a terrible trap to fall into.
The rest of this article is dedicated to learning what it means to be upside-down on a car loan, how to avoid it, and how to get out of it. Enjoy!
Upside-Down Car Loan Defined
When you borrow money to buy a car, the lender puts a lien against the title. That means that if you decide to sell the car, you must pay off the loan before the new owner can take ownership.
You have an upside-down car loan if the car is worth less than the remaining balance on the loan.
I know that this topic can trip up a lot of folks, but it doesn’t have to be super complicated. If your car is worth $15,000 and you owe $20,000, then you are upside down by $5,000.
If you sell the car, the lender does not care how much you receive. It is irrelevant. Here’s why:
When you bought the car, the bank wrote a check to the seller on your behalf. They have a right to get their money back, plus whatever interest you agreed to when you signed the paperwork.
Nobody tricked you into signing the car loan. You were not scammed. Therefore, you have a legal, moral, and ethical obligation to pay the debt in full.
Not only that, but if you don’t pay it in full then you will ruin your credit, the lender will try to collect the difference, and you will probably get sued… and lose.
That means you absolutely have to keep that car until you can find a way to clear the difference between what the car will bring and what you owe. Let’s look at two ways to get out from under an upside-down car loan.
Pay Down your Upside-Down Car Loan with Cash Flow
The best way to remedy an upside-down car loan is to get aggressive about paying off the loan using your cash flow.
If you are using my 12-step plan to eliminate debt and build wealth, then you may have a bit of work to do first.
If your car loan has a high-interest rate (more than 10%), then you would attack this loan in step 4, right after securing a 1-month emergency fund, but before putting money toward retirement. However, if the interest rate is lower, you may want to wait until step 8. That would mean saving a 6-month emergency fund first.
The point is to make sure that you have a strong financial foundation before aggressively attacking this debt. You don’t want to put all your money toward this loan and have a small emergency force you into credit card debt or (worse) payday loans.
When you have your emergency fund in place, you are ready to attack this loan.
At that point, you should have an Undetailed Budget, which will help you free up cash flow. Plus, you will have separated your income from your spending, which will help you escape the paycheck-to-paycheck cycle.
Make the minimum payment on absolutely everything except your car loan. Pour every extra cent you can squeeze out of your Undetailed Budget into extra principal payments on this loan.
You will be surprised how a single-minded focus on one goal can super-charge your progress.
Then, when you have paid down the loan and aren’t upside down anymore, you can sell the car and get something more affordable.
Pay Down your Upside-Down Car Loan with New Debt
If you are super over-extended, then paying down your car loan with cash flow may not work. You may not have any extra cash flow! In that case, there is a second option: pay down your upside-down car loan with new debt.
Let’s go back to our original example: you have a car that is worth $15k and a loan for $20k.
If you have good credit, apply for an unsecured personal loan. You will need to borrow enough to pay off the difference between your car’s value and what you owe, plus enough to purchase a modest replacement car.
In this case, you could try to borrow $10k. Then, when you sell the car for $15k, add $5k from your new loan to the proceeds of the sale and pay off your car loan. That will leave you $5k to pay cash for a replacement car.
This is a temporary car! And, the goal is for it to be reliable and not need any work! So, look for a nice reliable and inexpensive-to-service car, like a Toyota or a Honda with less than 200,000 miles.
When you started this process, you had $20k in car debt. Now, you only have $10k in car debt, which you should be able to attack faster and get paid off quickly now that you don’t have your old car loan.
As you can see, this method is not ideal. You did cut your debt in half, but you also still owe more than your car is worth. The difference is that your payments are lower and the loan is not a lien on your car’s title.
Of course, this method to get out of an upside-down car loan requires that you have good credit. Unfortunately, that means it won’t work for everyone.
Private Sale versus Trade-In
Regardless of which method you use to get out of an upside-down car loan, it is important that you maximize the value of your car. That means not trading it in!
When you sell your car to a dealership they pay you the wholesale value of your car. Then, they turn around and sell it to someone else for the retail value.
When you are upside-down on your car it is incredibly important to remove the middle-man. You need to sell your car for the retail value.
The best way to see the difference is to look up your car’s value on Kelley Blue Book. It will show you the difference between trade-in (wholesale) and Private Party (retail).
They will also make you an instant cash offer, which is a bad idea since you are trying to maximize how much you get for your car. Or, they will show you how to donate your car, which is also a bad idea in this circumstance.
Generally, there is nothing wrong with trade-in, instant offers, or even donating your car. However, because you are upside-down on your car loan, you need to get every dollar you can out of your sale. So, stick with Private Party.
When you have an idea of how much your car is worth, then you can sell it.
Clean it up, take good pictures, and list it for sale. Facebook marketplace can work well, or you could list it on one of the websites specifically for used cars, like Auto Trader. Craigslist used to work pretty well, but recently it seems like the only responses you’ll get are from scammers.
Never do a Voluntary Surrender
Getting out from under an upside-down car loan is never pleasant. There really are not any shortcuts. You borrowed money on an asset that goes down in value, and there is no way around it.
It is easy to get discouraged, throw your hands up, and just want to quit. At that point, you may feel the lure of a voluntary repossession. Don’t do it!
A normal repossession happens when you stop paying your car loan and the bank decides they’ve had enough so they come get the car.
On the other hand, a voluntary repossession happens when you are still current on your loan. You call your lender and tell them you just don’t want to pay the loan anymore and they can come pick up the car.
This is a trap.
When your car is repossessed, your lender will sell it at auction. Cars sold at auction often bring less than wholesale!
After the lender sells your car, they will come after you for the rest.
Remember our example? Let’s say you owe $20k on your car and you could get $15k for it Private Party. You could probably get about $13k for it trade in.
Well, if you do a voluntary repossession, your bank will probably get about $10k for it at auction.
So, now you’ve gone from being $5k to $10k upside-down on your car. And, you don’t even get to drive it anymore! Plus, you have tanked your credit, so you cannot borrow for a replacement.
Compare that to the second paydown option from before. In that case you had $10k of debt and a car to drive. If you do a voluntary repossession, you will have $10k in debt and no car to drive!
A voluntary repossession makes a bad situation worse. It happens every time. So, a voluntary repossession is never a good idea. Just don’t do it.
How to Avoid an Upside-Down Car Loan
An article about upside-down car loans would not be complete without a reminder of how to avoid the situation in the first place.
I was upside-down on a car once in 2002. At the time, I bought a brand new Chevrolet Trailblazer because I had graduated from college, had a fancy job as a financial advisor, and I knew I needed a good car so that my clients thought I was successful.
I was an idiot.
As a result, I was trapped in that Trailblazer and it took me about three years to get out of it. In 2005, I wanted to go back to school, but I had to get rid of that Trailblazer first. So, I did the first approach (paid it down aggressively out of cash flow), sold it, and bought a 1998 Pontiac Grand Prix with cash. And, I swore that I would never be upside-down on a car loan again.
Here’s how to do it.
Never Buy New
First, buying a new car is never a wise financial decision. Cars go down in value. And, the biggest depreciation happens in the first year.
If you want to buy a newer car, check out Carmax. They primarily sell lease-returns which are between one and three years old with low mileage.
Of course, there is a caveat that if you are wealthy enough that a new car is a relatively small purchase, then there is nothing wrong with paying cash and buying new. Sure, it is not a good financial move, but not everything is about money.
Car Buying Rule of Thumb
When you buy your used car, I recommend the 20 / 4 / 10 Car Loan Rule of Thumb:
- Put 20% down.
- No more than 4-year loan.
- Payments no more than 10% of gross monthly pay.
If you have good credit, this will be significantly less than you qualify for. But, this is the maximum you should spend. In fact, spending even less will help you speed through your plan to eliminate debt and build wealth faster.
Cars go down in value. The more of your net worth you have tied up in cars, the harder it is to get ahead. So, spend less!
Keep Your Car Longer
If you follow the car buying rule of thumb, then you will have a fully paid-off car in 4 years or less! You won’t be upside-down, and you won’t even have a car payment!
Do not rush out and replace your car payment. Just keep driving your car for a while and see what it is like to not have a payment. I promise you will like it.
You can use that extra cash flow to boost up your savings. After just a few years you should have enough in savings to trade in your car for a nice upgrade. And, you can pay cash for the upgrade!
Basically, if you can trade cars approximately every 7 years, and you are buying lease-returns, you should be able to never have another car payment for the rest of your life.
Now that’s freedom.
There’s a bit of irony that Americans can trade their love affair with cars for their love affair with freedom…
As Americans we love our cars. We spend a huge amount of our income on them. And, we spend a huge part of our lives driving them around.
For most of us, cars are the largest purchases we make that go down in value. So, it is important to be intentional about how much we sink into them.
When you buy a car, make sure it is used, put 20% down, get a loan for 4 years or less, and keep the payment to 10% of your gross pay or less. Plus, if you keep you car for about 7 years, then your current car loan will be the last loan you ever have!
But, before you start the path to living without a car loan, you may have to clean up the loan you have now. If you owe more than your car is worth, then you have an upside-down car loan. There really are just two ways to get out of it:
- Pay down your loan with cash flow, or
- Use new debt to get out from under your old car
Unfortunately, both approaches are hard. There really aren’t any shortcuts. And, a voluntary repossession will just make a bad situation worse.
So, buckle down, find a way to get your loan balance down, and make sure to sell your car Private Party!
What to Read Next
For more information, check out these articles that offer more detail about these topics. Enjoy!
- The 12 Steps to Eliminate Debt and Build Wealth
- The Undetailed Budget: the Best Tool to Take Control of Your Money
- How to Break the Paycheck-to-Paycheck Cycle
I hope this has been helpful! Join the conversation by adding a comment below.
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