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How to Avoid Upside Down Car Loans

By | Published February 24, 2012

I'm sure you have heard thousands of car dealer radio ads that scream out "We'll pay off your car loan no matter how much you still owe!" This scam is aimed directly at people like you who might be under water on their car loans. Over the years I have seen car buyers make many mistakes, and probably the worst mistake you can make is allowing yourself to become upside down on your car loan. This means you owe more money on your vehicle than it is worth, and usually between $5,000 and $7,000 as most of our visitors tell me. But how do so many people fall into this trap? Today I'm going to tell you all about what it means to be upside down on your car loan, how people fall into this trap, and how to avoid this devastating financial situation.

The Causes of Being Upside Down

You must first understand how used car values work, in order to see how this situation develops in the first place. The chart below shows a typical 10 year depreciation curve for most cars. The problem here is most people are unaware of this. Unlike real estate, which for decades pretty much increased in value year over year, cars drop rapidly in value, and have their biggest drop in value in the first 3 years. This chart shows a new car starting off with a $30,000 value, and losing about 25% value in the first year alone. By the second year, the car has lost about 30-40% off its original value. By the 3rd year, most cars have lost about 50% of their value.

Upside down car loan blog piture 1

This 3 year mark is shown above on the blue line when most cars come off lease for those who signed a 36 month contract, and the lease residual values assume there will be 50% depreciation. The chart above shows us that the steepest part of the depreciation curve occurs in the first 3 years. If you trade in a used car, the dealer gives you thousands less than market value, further adding to your depreciation. This is why we advise people to buy a 3 year old used car instead, as the previous owner already took the depreciation hit. Also you will still have one year left on the manufacturer's warranty. You'll almost always get more money for your used car by selling yourself, but if you're upside down and don't have the cash to pay the bank for the difference when you sell it, then your only choice is trading it in, or refinancing your car loan to get the payments lower.

Adding fuel to the fire of being upside down

Knowing the above information, you can look at the blue curve line and say that you should never take on an auto loan with a balance that is higher than that blue curve. The problem is many people put no money down after hearing the ads, so right off the bat they owe more than their new car is worth. Here's a great real life example for you. Suppose you are buying a Toyota Highlander in the southeast with a selling price of $30,000 and 6% tax ($1800). Next the dealer sells you their add on extras nonsense like $400 VIN# etching, Dealer Prep of $600, Credit Life for $700, a $2,000 extended warranty, and the infamous $600 Toyoguard Protection Package. Suddenly your $30,000 car purchase turns into $35,500. Notice how all the extras add up to extra cost for you, but don't necessarily add any intrinsic value to your car later on when you sell it.

Effect of high interest rates to people with less than perfect credit

Now assume you finance your new Toyota with no money down, so you are financing 100%. You borrow $35,500 for 72 months at 15% APR, you will owe a total of $54,046 by the end of the loan, because of the huge amount of total interest on your loan of $18,546! A person with a higher credit score than you might only pay 5% APR, with interest totaling a fraction of yours at $5,664. What a huge difference in suffering. This is where most people with bad credit don't see the unbelievable damage caused by financing a car with a high APR, just how badly it costs you. You are almost guaranteed to be upside down on your car loan if you have a high APR. Don't make the mistake of just looking at the selling price of the car, because that is not the amount you owe. With extras and interest, your actual amount owed can be $5,000 to $20,000 more than the car itself. This is what trips everyone up. What makes things worse for you is that most of the interest is paid in the front end of the loan, so your principal is getting paid off at a much slower rate than the interest. So if you buy the car today and you need to sell it quick one year from now, it will only be worth about $22,100 but your loan payoff will be much more than the value of the car, usually at least by $5,000 according to most of our visitors who contact us. Now you're stuck big time, and you're at the mercy of greedy salespeople who take advantage of your situation to low ball your trade in, using their cash flow shell games to confuse you, blind you, then rob you of the value of your trade in.

Disturbing trend: Car loan periods stretching out 60-72 months

Adding more fuel to this fire is the news CNBC announced today that 6 year and 7 year car loans are Up by 47%, which I find to be very alarming. This means more and more people are violating my rule of thumb of not financing a car longer than 48 months. It also means Americans are putting aside their common sense and not managing their money properly. Do you really want to be paying off a car for 7 years. It's becoming the norm, so now everyone is being corralled by the car dealers into long term loans so they can sell more cars at the expense of putting you in a poorly leveraged financial situation. They are training you like feeding the ducks into accepting this as the new norm. If you stretch out the loan to 6 and 7 years, you will fall much farther behind the depreciation curve, and be even further upside down. It will take you too long to reach the break-even point where the car is worth more than you owe. Many people never reach the break-even point.

The reason people are choosing longer car loans is because they want the lower monthly payments, and they refuse to settle for less car. The younger self entitlement generation wants the best no matter the cost, and they stand there with their hand out for help when it fails them. You should always analyze whether you really should be buying that car now. Now with increased extended loan terms they become slaves to their car payments and mortgages, which consume their lives. This chart below shows you visually how car buyers get upside down on their auto loan, by simply borrowing more than the value of the car, so the red payoff line there is steeply above the car's value until the break even point usually until year 5 or 6. In the chart example below, you could improve things a bit, by doing a 36 month loan, you can imagine how the red line would change, ending at Year 3 instead of Year 7, but you can see that you would barely break even by time you pay off the loan in 3 years.

Upside down car loan blog piture 2

Major factors causing you to be under water on your car loan:

Car dealers take advantage of you in this situation.

All those unethical car dealer radio ads are designed to draw you into their lair where they pull out the stops and unleash all their tricks on you. People who are upside down on their loans are the biggest victims providing dealers with some huge profits, this is why you hear these ads all over the place, there's a lot of money to squeeze out of undisciplined foolish people who spend with their hearts and not their brains. These transactions are a very complex set of smoke and mirrors which is why they rake you over the coals so easily, like stealing candy from a baby. Here's what the dealer is really doing to you by "paying off your loan no matter how much you owe:"

  1. Sells you a new car at full price because you're desperate to get out of your car
  2. Low balls your trade in even more because you're desperate and don't understand the numbers
  3. Pays off your loan with your current lender
  4. Rolls that payoff amount into your new car loan
  5. Now you are paying off 1½ cars

Hey, how many of you were speed reading so fast that you missed the last 2 words of item 5 above. Most people have no idea they are now paying off effectively 2 cars after completing this transaction. That's right folks, this is the core of their scam, you are still paying off what you still owed on the first car, AND you are now also paying off your new car! The beauty of this scam is most victims don't even know they are a victim. The finance manager spreads out the monthly payments over 7 years which causes you to have a lower payment and still think you're saving money. But in fact you're lining the dealer's pockets with thousands more over those 7 years. What started out originally as maybe your 5 year loan elsewhere a year ago, just got renewed to a 7 year loan, meaning you are now looking at years to pay off your car, plus the dealer managed to sell you a new car at the same time! I can assure you that you had no business buying that new car either, just like you had no business being in the original deal that you had. They dipped you out of your current loan, and dipped you into their new loan, now you owe all that money to them. They are laughing and high-fiving as you drive out, oblivious to the danger you just put yourself in. Years after you drive out of the dealership, you'll still be paying the price for your ignorance.

One of the worst mistakes consumers make when trading in a car

They think that trading in means they no longer have the burden of that debt any more!

Do you see what the dealer just did to you above? They tricked your brain into thinking they paid off your loan and you are no longer a slave to it. Listen to my warning here that one of the worst mistakes consumers make when trading in a car is they think that trading in a car means they don't have that debt any more. This is just what unscrupulous dealers want you to think. If you owe $10,000 on a car when you trade it in, you still owe that debt to someone, it does not just disappear. It might not be your original lender that you owe the $10,000 to anymore, but you do still owe that $10,000 debt, it does not just disappear. This is where consumers just get it so wrong, failing to understand the mechanics of owing a debt. Think of a debt as excess luggage that follows you everywhere you go.

How to prevent being upside down on your car loan

Now that you know the mechanics of what causes this scenario, it's easy to avoid it. The basic strategy is to always be sure you are borrowing less than the car is worth. We have always suggested putting down 20% on the car and finance no longer than 48 months. If you cannot do this, then do not buy the car. It's that simple. Do some soul searching, learn to live with less, but make sure you remain inside my guidelines that I outline for you here; they are designed to keep you out of trouble. If your pride is unwilling to settle for something that fits your budget, and you think I'm on my high horse, and you want to get into trouble, then by all means ignore my advice. I'm on a mission to get all of us living within our means. I'm telling you that 48 months is the limit of our means. If we can't get a sustainable monthly payment to fit into this criteria, then we are not living within our means, and we need to correct it now, or veer of course later.

Here's our tips to avoid being upside down:

The chart below shows how your car loan should be structured. Using our same Toyota example earlier, the $35,500 total purchase should have a down payment of 20%, or about $7,000.

Upside down car loan blog piture3

This means we should not borrow more than about $28,000, which is comfortably less than the new car value. See how our green line stays below the car value depreciation curve the entire time. Try to pay off your loan as soon as possible; you will save a lot on interest too. I usually pay mine off in 3 years. If you're stuck in a high APR loan right now, look into refinancing to a lower rate to reduce your payments. You should never trade in your car to buy another car in an attempt to lower your monthly payments. Be sure to think everything through before you buy, and keep all our advice in mind, and you'll enjoy financial peace in your life.

Author Jeff Ostroff

About The Author: Jeff Ostroff is a consumer advocate, Founding Editor and CEO of CarBuyingTips.com overseeing a team of expert authors. For over 17 years, he's been the recognized authority on car buying, leasing, used cars and financing. He developed sophisticated spreadsheet tools to help consumers negotiate on a level playing field. He is a widely sought out guru, cited by the press for his expertise in savvy car buying and preventing consumer scams. Jeff has been quoted in CNN, Bloomberg, MSNBC, Wall street Journal, Consumer Reports, NY Times, Reader's Digest, and many live call in radio shows. He has covered the automotive space since 1997. Jeff also has extensive experience and expertise in selling used cars for clients on eBay and Craigslist. Connect with Jeff via Email, Twitter or on Google+.

CarBuyingTips.com has affiliate referral relationships with multiple web sites. This means that for many of the links you see on this site, we are paid referral fees for leads generated from visitors that click on links or fill out forms on this site. In some cases we are paid a commission for a purchase made on a site that is linked to from CarBuyingTips.com. Please view our advertising policy page for more information.