What if I owe more on my trade than it’s worth?

A car, especially a new car, depreciates in value as soon as you drive it off the lot. That makes it easy to end up “upside down” on your car loan.

Being upside down means you owe more money on your car than it’s worth. If you’re looking to get a new car, this poses a dilemma: What do you do with your current vehicle? How can you pay off your current loan? Can you fold the remainder into your next car loan? Should you?

There are plenty of details to sort out, but let’s start with some basic truths:

Truth 1: You borrowed money from a financial institution. You have to pay this money back.

Say, for example, you still owe $10,000 on your current car, but that vehicle is worth only $7,500. You need to cover that $2,500 gap, one way or another.

And this is where we go from simple truth to financial details. There are multiple paths to that $2,500, from taking a second job to selling your childhood comic book collection to taking out a home equity loan to rolling your debt into another vehicle.

All of these options have pros and cons. Some allow you to solve your debt issue immediately; others let you delay full repayment until months or years down the road.

Truth 2: You can improve your situation by reducing your loan amount, improving your loan terms, or stretching the duration of your loan.

The best case scenario is that, one way or another, you’re able to pay off your debt in full. However, that may not be possible—or even the best option—depending on your financial situation. That’s why another way to relieve the pressure from your upside down car loan is to transfer your debt to another, lower-interest loan, or refinance (plenty of details on those options below).

Think about your debt as water left in a faucet. Assuming you’ve stopped taking on debt, the supply of water left in the pipes is fixed, but it still needs to come out before the all clear. If you open the spigot fully, you’ll flush the water out in a few seconds—drain all your debt at once.

But that may cause catastrophic flooding across your financial landscape. Extending your loan is the equivalent of opening the faucet just a bit, allowing a manageable amount of water through and preserving your financial landscape. But it may take a while to clear the pipes.

This isn’t a perfect analogy. Sometimes extending the length of your loan also incurs more interest (i.e. adds more water to the pipes). It may give you an idea, though, of what’s more manageable for your situation, whether it’s draining the pipes at the cost of near-term personal pleasures or some of your savings, or whether you desperately need to restrict the flow for the next few months.

Truth 3: If you sell, you need to maximize the resale value of your car.

Yes, it seems intuitive—until you attempt to put the plan into practice. As we’ll show, some of the quickest paths to unload your current vehicle simply prolong or expand your indebtedness.

Even as you search for ways to make up the difference between the value of your car and the amount of your loan, remember that your car is still the most valuable piece of the puzzle. It should get you most of the way toward financial solvency.

That’s why getting the maximum resale value for your car is so critical. A few percentage points in resale value make a much bigger difference than an extra bid or two for your Blu-Ray collection on eBay, or an extra few tips on your pizza delivery run.

You can walk into a dealership today, and they will cut you a check (or put the value of your current car toward a new one). But if you don’t do your homework, you may unknowingly transfer thousands of dollars in resale value to the dealership by accepting a low-ball offer.

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How You Got Upside Down on Your Car Loan

There’s more than one way to end up upside down on an auto loan. This process is critical to understand if you’re exchanging one vehicle for another.

Nothing will be as important for avoiding another negative situation as knowing how you can end up in one in the first place. Don’t escape one mistake by making another.

Here are the five ways you can end up upside down on your loan:

1. You Bought a Car You Couldn’t Really Afford

Of all the ways to end up underwater on your car loan, this is the simplest one to understand—even if it’s the hardest one to resist. Cars have a special place in our psyche, and few of us grew up without some ideal car, whether a bright red Camaro or the more mature luxury of a Mercedes Benz SUV.

Car buyers with the same income may be willing to dedicate varying amounts to a car payment. Certainly, someone who spends the week traveling around British Columbia on business might find more benefits in a comfortable ride compared to someone who hops in the car only for short trips.

Most financial experts recommend that a car payment should not exceed 10 percent of your gross income, no matter what you make. That means if your income is $52,000, your car payment shouldn’t exceed $520 per month.

2. You Didn’t Have a Down Payment (or Enough of One)

Often, car buyers stretching their budget end up purchasing a car with no down payment. It’s the cheapest way to get off the lot without opening your wallet. However, most new vehicles depreciate by 20 percent the moment you drive off the lot, which is why it’s so easy to get upside down on a car loan with a new vehicle and no down payment.

Take a $30,000 car as an example. Once those four tires leave the dealership, your $30,000 purchase is worth just $24,000. That’s right—you’re already $6,000 upside down. Even if you’re able to maintain payments, this still presents a risk.

Most insurance companies reimburse clients for damaged or stolen vehicles based on a car’s value, not the amount you owe. So if the first turn out of the dealership results in an accident, don’t expect your insurance company to come to the rescue. (Some insurance companies offer new-car replacement within the first year of ownership.)

One pragmatic option is to ensure your down payment covers this initial loss in value. Another option is to purchase gap insurance, which, in the event of an accident or theft, covers the difference between the insurance payout and your loan balance.

3. You Had a High Interest Rate

Interest rates depend on many factors, most notably your credit score. Other considerations include your work history and current income, as well as any credit card debt and your home loan. Even alimony and child support may affect your interest rate. Whether you’re working with a dealership or a lender, their primary concern is limiting risk.

You may not have qualified for a low interest rate during your last vehicle purchase, and you still may not be in a position to get the lowest interest rates a lender offers. Getting prequalified before getting on the lot—or as soon as you arrive—can ensure thoughtful decision making and prevent signing up for a high interest rate in a rush to finalize a deal.

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4. Your Loan Term Was Too Long

Extending your loan term can stretch your budget when financing car. Your monthly payments are the amount borrowed plus interest, divided by the term of the loan. Lengthening your loan term means dividing your loan amount by more months, resulting in lower monthly payments.

However, it also means more months paying interest (and, typically, a higher interest rate). This can result in hundreds and sometimes thousands of dollars in additional interest payments. It can be a strategy of last resort, and we’ll tackle that later. But before you sign a 72- or 84-month lease, calculate the total costs, not just the monthly burden.

This factors into getting upside down in another way, too: By the time you get around to year six or seven on your repayment schedule, your car may have depreciated enough to make its resale value less than what you still owe.

5. You Rolled a Previous Car Loan into Your Current One

Rolling over your loan is always a tempting option, and it can provide temporary financial relief while also getting you into another vehicle.

Still, remember that each time you roll an old loan into a new one, your total debt increases. If you’re not careful, what may have started as a snowball can become an avalanche, one in which being upside down on your car loan is a permanent state, no matter how long you keep your car.

Some dealers promise to pay off your existing loan—even if you’re underwater—and give you a brand new car. But your existing debt will be rolled into your next round of financing. That may mean a higher monthly payment, an extended loan term, or both.

Ways to Get out from under Your Car Loan

First things first: This is not an either–or situation. Some options are mutually exclusive, but the best plan for you may combine several of the strategies detailed below.

Cut and Pivot

Selling your existing vehicle is often the first thought that comes to mind. And it may be the best one. But before you sign over your title to a dealership (or even a neighbor who’s long admired your ride), consider some of the alternatives and see if there’s a better fit for you and your budget.

Employing some of these strategies in the near term might provide you with temporary relief and better position you to sell your expensive car several months or a year down the road.

Keep Making Payments until You Can Break Even (or Afford the Difference)

Making payments for a longer period of time will bring you closer to breaking even, eliminating the upside-down status of your loan. Of course, if you felt like you could make the payments indefinitely, you wouldn’t be stressed financially in the first place.

Still, even a few extra months of payments might lighten the financial burden of your upside down loan. Are there other areas of spending where you could cut back, even a little? Shuffling some of that cash to your car payment might get you closer to the tipping point. Every little bit helps, even if you end up selling your car in the not-so-distant future.

If your financial squeeze is approaching but not yet here (say, it’s an eight-pound bundle arriving in about nine months), check to see if there are any prepayment penalties on your loan. If not, throwing an extra $30–50 at your car loan each month while you have the financial flexibility can help you get closer to level when the real cash crunch arrives.

If you can get by without your car for a few months, consider parking it in the garage (or safely on the street) and cancelling your car insurance for a period. This could save a few hundred bucks, which you can put toward paying down your principal. Just make sure you get reinsured before you take it for a drive again. You’ll also prevent additional wear and tear on the car, save on gas, and maybe even get some much-needed exercise!

While unconventional, this strategy works well if you’ve recently become unemployed and no longer need to drive daily to your job. Public transit or a lift from a friend can help fill the gap and get you to job interviews. Similarly, if you’ve decided to eschew the corporate world in favor of starting your own business, you likely can survive a few months without an everyday vehicle.

Refinance Your Loan

Refinancing your loan starts by contacting the company that owns your car, whether it’s a bank or a dealership. If you’re able to lower your rate, it means that more of your monthly payment—even if it doesn’t change significantly—goes toward paying down your principal, which will close the gap more quickly between what you owe and what your car is worth.

Alternatively, refinancing may simply extend your loan term. This can be tricky, as extending your loan term typically means you’ll pay more total interest. However, if lowering your monthly payment is the most urgent priority, refinancing your loan term can provide that immediate relief.

In any scenario, time is of the essence. The quicker you refinance, the quicker you’ll get back to even on your car loan. Each payment on poor loan terms is money wasted.

Also, remember that lenders will be more willing to work with you if you come to the negotiating table before you get behind on your loan. If you fall behind, you may not have a car to refinance—vehicle repossessions can happen quickly and make it difficult to secure a car loan in the near future.

Shift Your Debt

Shifting your debt doesn’t resolve your issue, but it may make it more manageable. One option is to find a credit card with a balance transfer offer. This may give you the opportunity to enjoy up to a year without interest charges.

However, a word of caution: Introductory periods end, and the following period of interest may quickly balloon your balance. Make sure you know what will happen after the “honeymoon” phase is over with your new creditor. This makes the transfer option better suited to someone who needs a few months of relief to finish off a burdensome car payment; it’s unlikely to be a long-term solution. If you go this route, pay as much as you can, as quickly as possible.

For homeowners, a home equity loan is usually a much better option. You may be able to quickly raise the cash to pay off your auto loan while transferring that debt to a lower-interest home equity loan. For those with a good credit history, personal loans also provide the opportunity to transfer your debt to a lower-interest loan product. Your local bank or credit union is the best place to start for that.

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Raise Revenue

Cutting expenses and moving your debt to more favorable loan options can provide some relief. However, raising additional revenue may also be necessary to escape your upside down loan. Here’s how you can pair frugal spending and better loan terms with some additional cash:

Sell Some Stuff

What’s in your garage? How about the attic? Having a manageable debt situation may be more important to you than some old collectibles or heirlooms. Remember, at the end of the day, you’re simply looking to balance the amount you owe with the assets you have. And if your car can get you 80 percent of the way there, maybe you can find a way to raise the other 20 percent, or even some of it, with a yard sale or eBay selling spree.

Get a Second Job or Work Overtime

Still need more cash? Taking a second job, just for a short period, may offer a solution. While not glamorous, delivering pizzas or refereeing youth sports can make some extra money while not interfering with your day job. If you have the opportunity, a few additional shifts at your regular work might be the easiest way to get more cash in your pocket and lower your automotive debt.

Sell Your Car

Use Canadian Black Book to get general pricing for your car based on the make, model, year, mileage, and condition. Be cautious about overestimating your standard of care—only a fraction of all trade-ins qualify as being in excellent condition. Also, know the difference between the dealership trade-in and private sale prices.

Use eBay or Craigslist for additional market research. EBay includes filters to display sold listings only, which can also be narrowed by geographic area. It makes much more sense to figure out what a similar vehicle actually sold for, not just what sellers are demanding.

Because you still owe money on your car, you’ll need to get permission from your lender to sell. This is because you don’t own your car outright, and the lender still has a lien on your vehicle. You’re unlikely to run into any major hurdles, but checking in first will make sure that you fill out all necessary paperwork. In most cases, the total amount of your loan will be due before the title can be transferred.

Dealer Trade-In

As we’ve noted, the number-one benefit to a dealer trade-in is a check on the spot (or money toward your next vehicle). Dealers may also be willing to extend credit to car buyers because they have the added incentive of moving a vehicle off their lot. This may loom large when rolling your existing vehicle debt into another car lease or loan.

A dealership’s new-car incentives, such as rebates, may be enough to offset your upside down status if you owe only a couple thousand dollars. Be aware, however, that incentives typically are for new (and sometimes unpopular) vehicles, which may mean lower resale values.

To avoid getting stuck upside down on your loan a second time, you may need to hold onto that new car with the huge cash-back rebate for a year or two longer than high-demand vehicles.

You may also be able to escape the cycle by trading in your vehicle and taking out a lease. If a dealer offers exceptionally low lease rates, rolling your existing debt into a lease payment may be manageable, and after the lease is up, you’ll be debt free, since you don’t need to worry about getting upside down on a lease. The downside? You won’t have any equity in a car to trade in either.

Private Sale

Choosing to sell your vehicle privately often provides the maximum amount of cash. So why wouldn’t everyone do it? Because it takes time, energy, and a bit of know how. From keeping your car clean to advertising it across the Internet to negotiating the final price and title transfer, the process may seem daunting.

In some markets, you may find a third option: consignment. With consignment, you pay someone else to sell your car. Different auto consignment businesses charge different rates, some a flat fee, others a percentage of the sale price.

After you subtract the consignment fee, you may or may not walk away with more cash than if you sold your vehicle to a dealer. It’s worth doing the math before you make up your mind.

The End Result

So what makes the most sense for you? Trading in your vehicle? Working a few extra shifts? Taking out a home equity loan? Hopefully, we’ve provided some answers—or at least given you a picture of all the paths you might pursue.

If you’re not sure, get in touch. We’re happy to talk through your situation and find a sustainable solution that meets your needs. Or, if you prefer, fill out our online credit application to start the prequalification process today!

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