Upside-Down on Your Car Loan
When you buy a car – like virtually no other material possession commonly purchased, you will take an immediate hit on depreciation of its value. What that means in layman’s terms is that the second you drive a new vehicle off the lot, it is worth significantly less than what you paid for it. If you buy a $20,000 car on Wednesday and drove straight to the local newspaper office to place a classified ad to sell the car, by the time you got your first calls that weekend, the vehicle would not be worth $20,000. If you have taken out a loan for that $20,000, you will owe more than the automobile’s value and be therefore unable to sell it. This is what is known as being “upside-down” in your loan. It is a phenomenon that affects most new car buyers in the country, but that does not mean that it is unavoidable.
Make a Large Down Payment
One way to avoid being upside-down on your car loan is by putting down a greater down payment on the vehicle when you purchase it. This means that you will have to come up with something that is a good percentage of the final asking price. This is advantageous not only in providing you with a loan that is smaller than your car value and giving you the flexibility of choice, but it also increases your negotiating power at the dealership. The more cash you bring and the less financing will be an issue. The less any salesperson will have to hold over you as doing you a favor during the sale.
Coming up with 20% or more of your purchase price as a down payment for the car is a very good way to avoid going upside-down in your auto financing. On average a new vehicle will depreciate about 20% in its first year. That means that if you paid nothing on the vehicle in the first year (good luck with that), at the end of that year your automobile would be worth exactly what the loan on it is.
Make Large Monthly Payments
Another way to avoid being upside-down is to increase your monthly payments – by at least 25%. If you buy a $20,000 car for $20,000 at the end of the first year that vehicle will be worth about $16,00. Your car payments are likely to be somewhere just under $400 if you bought the car at 7% interest on a 5 year-loan. If you just pay $400 per month, over the first year, your balance at the end of that year will be more than $16,800, and the difference between what you owe and what the automobile is worth will continue to increase for awhile until you begin to reach the end of your 5 year agreement. If, on the other hand, you paid $500 per month to that loan, at the end of the year your balance would be less than $15,800, putting you slightly ahead of the game. This option is actually more expensive than just coming up with the larger down-payment up front, since you will end up paying more interest over time. Also, the extra $100 per month is going to “hurt” more every time you have to write that check.
Select a Short Loan Term
Short-term vehicle financing is rare, but not unheard of. If you have the means for it but don’t, for whatever reason, want to pay with outright, you can set yourself up with a 2-3 year loan instead of the standard 4-5 year loan. This will force you to make the aforementioned larger monthly payments and help to keep you ahead of the depreciation curve.
Finally, any combination of the three methods above will help keep you from getting upside-down in your financing as well. Can’t come up with a 20% down payment right now? Terrified at the idea of putting an extra $100 per month into your car? Not ready for a 2-year car loan? Try 10% down on a 3-year option.