Dear Dr. Per Cap: I just bought a new war pony. It’s a nice vehicle but last week when I traded in my old ride the car dealer told me that I was “upside down” on my loan and would need a new loan for more than the cost of the new car. That seemed ridiculous but I really needed a new ride. So, what gives? And what does it mean to be “upside down” on a car loan?
Signed, Confused and Frustrated
Dear Confused and Frustrated:
Ok, your dilemma is pretty common these days, and unfortunately it all goes back to when you bought that war pony you just traded in. Here’s an example to put things in perspective. Let’s say a person wants to buy a vehicle that costs $31,000 (the average price for a new car in the U.S. according to TrueCar.com…….yikes!). However, he only has $5,000 to put down so he needs a $26,000 loan to make up the difference. Now let’s say the buyer is in his early twenties, carries high credit card balances, or has other issues that hurt his credit. The dealer, or whoever it is that he’s applying to for a loan, considers him a riskier borrower and the best interest rate he can offer is 13%. Now, for most folks a sensible car loan should have an interest rate of 8% or less. And it shouldn’t be for much longer than 3 years or 36 months. But this guy is stuck with a 13% interest rate and with a 3-year mortgage, that would mean a Godzilla-sized monthly payment of $876, which is more than most people are willing to pay each month. So the easiest way to lower that payment without buying a cheaper car is to extend the life of the loan, to, let’s say, six years or 72 months. This now spreads the payments over more years and lowers the monthly payment to a more affordable $521 per month. The buyer can now afford the car, and everyone goes home happy, right?
Wrong! The problem is that the buyer is now paying a lot more for the loan because even though his monthly payment is less, he’s making twice as many payments. In fact, as the chart below shows, the cost of credit (the amount paid for interest in addition to the original $26,000 borrowed) after 6 years is more than $11,500! Hey, that’s enough to buy a good used car…..hint, hint.
3 years or 36 months Loan Term
13% Interest Rate
$876 Monthly Payment
TOTAL COST OF LOAN $31,536
TOTAL COST OF INTEREST ON LOAN $5,536
6 years or 72 months Loan Term
$521 Monthly Payment
TOTAL COST OF LOAN $37,512
TOTAL COST OF INTEREST ON LOAN $11,512
Now think about how much a car will depreciate, or lose value over the length of the loan. Miles driven, every day wear and tear, and other factors cause most new vehicles to lose about half of their value in the first five years. In fact, it’s not uncommon when a borrower makes a small down payment (less than 25% of the purchase price) on a high interest, long-term auto loan that the car can actually depreciate faster than you can pay it off. So the car can lose value faster than you can pay down the loan – and this is especially true if you put a lot of miles on the car each year. So that is what it means to be “upside down” on a loan: You owe more on the car than it’s worth.
And in your case, because your old war pony was worth less than the amount you owed on it, the dealer simply tacked that outstanding loan balance onto your new loan, leaving you with an even bigger loan. It also meant that you had no equity, or value, left in the old vehicle so when you traded it in, you didn’t get any extra money for the down payment on the new purchase. A tough break, one that makes you miss simpler days when war ponies ran on hay instead of gasoline.
So how can you avoid being “upside down” on your next car loan? Here are some tips:
Pay at least 25% of the purchase price of the vehicle up front when you buy it.
Try to avoid car loans any longer than 3 years or 36 months (but up to 5 years is ok).
Push for the lowest interest rate possible – 8% or less is ideal. And shop around to find the best deal!
Don’t let your monthly car payment and cost of insurance exceed 25% of your total monthly income.
Take good care of your vehicle – try to drive fewer than 12,000 miles a year and keep up with scheduled maintenance and repairs.
Follow these five simple steps and I guarantee you’ll never be “upside down” on a loan again. I understand this might mean you’ll have to purchase a more modest war pony than you had hoped for, but who cares? It’s the person driving the car that counts, not the other way around!