Is Your Car Financing Upside-Down?

We all know what it means to be upside-down in the physical sense. The blood rushes to your head and it's hard to breathe, all because it's not the natural state of the human body. In vehicular terms, being upside-down is a completely different, yet equally unpleasant phenomenon. When it comes to your car, truck, minivan or SUV, being upside-down in your car loan is not a physical problem, but a financial one.

In car dealership slang, it simply means that, late in the life of your auto loan, you still owe more money to your car financing organization than the vehicle is now worth.

How Does It Happen?

Here's an example. You buy a $30,000 car with $2,500 down, finance it over a common 60-month term, but in three years you decide you want to sell it. Your payoff on the auto loan is $18,000, but your car is only worth $15,000 at this time. This means you are $3,000 upside-down, because in order to pay off your original auto loan, you would need to make up the difference between what your car is worth ($15,000) and what the car loan payoff is ($18,000).

Being upside-down in an auto loan isn't all that uncommon these days, although there are no published industry figures. Jim Moynes, vice president, automotive marketing for Ford Motor Credit Company, one of the world's largest auto finance companies, says that "negative equity," or being upside-down, depends to a great extent on how you structured your purchase in the first place.

He says, "A large portion of the vehicle's depreciation occurs in the first two to three years of ownership, regardless of make or model. Loans amortize over the term of the loan you took out, and typically there's a period there where the depreciation outpaces the amortization. When you're in that period, you're in a position where you have negative equity. Once your amortization crosses over that line of the depreciation curve, which typically flattens out as the vehicle gets older, you get back to equity."

Longer-Term Auto Financing

Moynes says that the ready availability of longer-term auto financing, car loans that are 48, 60 or even 72 months, means that it will take longer to get into an equity position with your vehicle. He also points out that, just because you get into a negative-equity situation with your car loan, it won't necessarily affect your overall credit score, but it could affect your purchasing power, and it could impact the auto loan rate you get for your next loan.

Moynes explains that extended-term financing isn't necessarily a bad thing. "It all depends on buying habits. That might be OK for the consumer who likes to keep vehicles for extended periods, and that's certainly a stronger option for all consumers, because of the ever-improving quality of vehicles. It does improve affordability, and as long as it matches up with the trade-in frequency, then they're perfectly fine and it will work very well for them."

He goes on to clarify where the real risk lies. "If you're a consumer who likes to purchase a new vehicle on a fairly accelerated frequency, say 24 to 36 months, then that extended financing may mean that you end up with negative equity when you go in to trade your vehicle."

Lease or Buy
Moynes says that if you are the type of consumer who likes to drive newer vehicles all the time, trading in every 24 to 36 months, perhaps car leasing would be a better deal than long-term car financing. "For many consumers, leasing allows them to get into a new vehicle with the finance company assuming the responsibility for the residual value, what that vehicle will be worth in two or three years, so you can turn it back in and have a worry-free transfer experience into your new vehicle."

He notes that certain types of drivers should be wary of leasing. "There are mileage restrictions, so if you drive a lot of miles, you may have to pay a mileage penalty. If you have a truck and you take it off-road, there can be excess wear and use charges. If you like to upfit your vehicle or put aftermarket equipment on it, that probably won't be allowed."

How to Mitigate Your Risk

Moynes says a consumer should structure an auto loan with the down payment large enough so that the monthly payments, the number of payments, and the time he or she wants to keep the vehicle match up as closely as possible to avoid getting upside-down.

Co-signers, or as Moynes calls them co-buyers, adults who may help their sons or daughters buy a new car with their better credit ratings and credit history, should also be wary of long-term car loans, because they are liable for the full payment of the obligation that they sign up for.

Consider using an auto loan calculator to enter the price of the car, the value of your trade-in (if any), your car loan rate and loan term to determine your monthly auto loan payments.

"You can offset the amount you're financing by making a larger down payment. You should also take advantage of any programs that the manufacturer might be offering, whether that be a low APR (annual percentage rate), or cash rebate offers that help reduce your balance. That can certainly help the situation," says Moynes.

For more information on this topic, visit our Car Loans center.