How to Get Out of an Upside-Down Car Loan

How to Get Out of an Upside-Down Car Loan

There are two main reasons why you may find yourself with an upside-down car loan:

1. If the car gets totaled, and the lender sells the car to earn back some money, you may have to pay a deficiency balance if you owe more than the lender gets from the sale.
2. If you want a new car and you decide to trade in your current vehicle, you'll have negative equity. You'll likely have to pay the difference between your car loan balance and the car's value out of pocket or add the negative equity to your new car loan.

Here's how to get out of an upside-down car loan.

1. Make Extra Payments

If you can afford it, consider accelerating your car loan payments. Even if you can only put a little more than your monthly payment toward the loan, that extra amount may directly pay down the principal balance, which will help reduce the amount of interest that accrues on the loan. Check with your auto lender to confirm that extra payments will, in fact, make a dent in the principal.

You can also consider cutting back on some of your discretionary spending, earning more income, or using a tax refund, a work bonus or other small financial windfalls to pay down your loan.

2. Refinance Your Loan

Refinancing your car loan can help you secure a lower interest rate, saving you money. If your credit has improved since you first applied for the loan, you may qualify for a lower rate now, reducing the chunk of your monthly payments that go toward interest charges. Then, you can continue to send the original loan payment amount to the lender and pay off the debt faster.

Switching to a shorter repayment term is another way to pay down the loan faster. Just make sure you can afford the new, higher monthly payment.

3. Keep Your Car for Longer

Unless you absolutely need a new car, consider driving your current one for as long as possible while you pay down your loan balance. Car depreciation typically slows over time, particularly after five years of ownership. So the longer you hold on to the vehicle, the better your chances your loan payments will catch up with depreciation.

In other words, as you pay down the loan, the car's value will continue to decrease too—but at a slower pace, meaning you'll eventually owe the same amount or less than the value of the vehicle.

Keeping your car for longer won't solve the problem of needing to pay a deficiency balance if your car gets totaled in an accident. But it would help you avoid compounding your negative equity by trading in the vehicle when buying a new car.

Learn more: How to Protect Your Car's Value

4. Sell the Car

If you truly need a new car, you can sell it in a private transaction or trade it in to a dealer. Keep in mind, trade-ins generally net you less money, since the dealer acts as an intermediary and will also want to earn a profit from the sale.

On the other hand, selling a car privately can get you more money, but it may take more time and effort. You'll need to post advertisements, communicate with potential sellers and manage the logistics of the sale. Selling your car to a different dealer than the one you buy your new car from is another option. This could give you more negotiating power, since you won't be forced to work with a specific dealership.

Learn more: How to Sell a Car With a Loan

How to Avoid an Upside-Down Car Loan

You can take steps to avoid the inconvenience and potential cost of being upside down on a car loan. Here's how.

• Make a larger down payment. If you put a substantial amount down when you first buy the vehicle, you'll have a smaller loan balance to pay off, lowering the risk of being upside down later on. Plan for a down payment of at least 10% for a used car and 20% for a new car.
• Request a shorter repayment term. This will ensure you pay down the loan quickly, limiting the likelihood you'll owe more than the car is worth in the future.
• Choose a vehicle that holds its value for longer. Cars that depreciate especially slowly will help you keep the car value and loan balance more closely aligned. That puts you in a better position to avoid an upside-down loan than if you chose a car that loses a lot of value right away.
• Avoid add-ons at the dealership. Pricey add-ons, like extended warranties and extra features, can increase the loan balance, potentially forcing you to pay it off over a longer time.
• Buy used or certified pre-owned vehicles. Buying used instead of new vehicles will help you avoid a significant drop in value during the first year.
• Get gap insurance. Guaranteed asset protection, or gap, insurance helps cover the gap between your vehicle's value and the outstanding balance on your loan if your vehicle is stolen or totaled in an accident. Without gap insurance, your lender will typically require you to pay the difference. But if you have gap coverage, you can file a claim to have that provider pay off the deficiency amount. You may want to opt for gap coverage as a precaution if your loan balance is much higher than the car's current value, you made a small down payment, you have negative equity from a previous loan or you have a loan term of five years or longer.

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The Bottom Line

It's possible to fix the issue of an upside-down car loan, whether you do your best to pay off the loan or take other actions like refinancing or selling it. The best course of action is to avoid being upside down in the first place by limiting your loan balance and choosing a car that won't lose significant value right away. Even if it's already happened to you, being upside down on a car loan can help you make even wiser choices when you finance your next car.