Most modern consumers fall prey to increased consumerism and a compulsive need to keep on improving their lifestyle, even if they really cannot afford it. Nowhere is this behavior more evident than in the periodic purchase of new cars that are bigger and better. Unfortunately, because these cars are very expensive, they can very easily land up in a situation where they are “upside-down” on their loans, which means that the money they owe to the lender, is more than the worth of the car. This situation, also known as ‘negative equity’ or ‘underwater’, may cost the car owner a lot of money in case the car is totaled, stolen, or even traded in.
How Can You Get Upside-Down on Your Car Loan
It is proven that new cars undergo a very rapid erosion of value in the first couple of years. This means that if your car is wrecked or stolen or if you want to trade it in for a new model, you could find that the worth of the car to be far less than what the amount of the outstanding loan is. Whatever be the circumstances, the net result is that you end up owing a fair amount of money to the lender because of the difference of what the insurance company will pay you or what the trade-in value of the car is with the amount of loan remaining to be paid. If the difference is not too much then there is no problem if you add it to the loan that you take for a new car, however, when you rollover substantial amounts, your monthly payment could be quite high and the chances of you getting stuck in an upside-down situation become worse.
Avoid Being Upside-Down By Buying a Used Car
The reason why more people get into a negative equity situation with new cars is because new cars depreciate in value very quickly. It is said that a brand new car loses around 20% of its value the minute you take its delivery. If the car is super-expensive then you can lose more. Averagely, in the first year, you can expect to lose about a third of its value. Buying a used car makes eminent sense because it would have already lost its value and would not only be far cheaper to purchase but also be better value for money. Loans needed for these depreciated cars would be less and you would find them easier to pay off.
Get On Top by Making a Substantial Down Payment
Even though it can be tempting to get the maximum amount of car loan, doing so exposes you far more to the risk of negative equity. By making a down payment of at least 20%, you can keep the amount of loan down, however, even by doing this you will be upside-down for the first few months since the car tends to lose the same percent of its value the very minute you drive it home for the first time. Making a larger down payment is more sensible if you can afford it. Don’t include the various fees and taxes into the loan to keep the loan amount down.
Negotiate the Lowest Rate of Interest
When you take a loan, apart from repaying the principal every month, you also need to pay the interest, which can be pretty substantial in the initial few years. Getting a loan carrying the least possible rate of interest can be really helpful in avoiding a negative equity situation because then you will end by owing less to the lender. Getting car loan rates online or inquiring with your local credit union or bank are the most effective ways of locating low-interest lenders.
Opt For the Shortest Possible Loan Tenor
If you can resist the temptation of stretching out your loan to reduce the monthly payment and instead opt for a shorter tenor by allocating a larger sum of money for the monthly payments, you will be able to pay off the loan faster. What you really need to ensure is that you can afford the higher monthly payment and that the loan tenor does not exceed five years. Anything more sharply increases the risk of being upside-down. In case, you are unsure of what the tenor should be, choose the same number of years that you plan to retain the vehicle.
Being upside-down on a car loan can be extremely upsetting and has the potential of spoiling your mental peace as well as your financial balance. Buying the least expensive car with a loan that is as small, cheap, and short as possible is the best way of not getting into trouble.
Author bio: Richard Knepper is a senior manager handling the car loans desk at a leading retail bank. Richard is also the editor of a monthly newsletter on car and consumer finance.