A caller to my radio show recently had a problem that unfortunately isn’t unusual. He owed about $20,000 on a minivan worth roughly $8,000. In other words, before he could even think seriously about replacing it, he had a $12,000 hole to climb out of.
He wanted to know what he should do.
My advice wasn’t particularly exciting: Keep the minivan. Take care of it. Make every payment on time. Send additional money toward principal whenever you can, making sure the lender applies the extra amount as intended. And perhaps most importantly, mentally accept that you probably aren’t buying another vehicle for the next few years.
Sometimes the best car deal you can make is no deal at all.
What my caller had is called negative equity, although most people simply say they are “upside down.” It means you owe more on the vehicle than the vehicle is worth. Being a little upside down early in a car loan isn’t necessarily a crisis. Vehicles depreciate, and loan balances generally decline more slowly in the early stages of a loan. If you like the vehicle, it is dependable, the payment is comfortable and you plan to keep it for years, negative equity may be nothing more than a number on paper.
The problem begins when you want or need to get out of the vehicle.
In my caller’s case, if the minivan is worth $8,000 and the loan payoff is $20,000, somebody has to account for that $12,000 difference. It doesn’t disappear because he trades the van.
This is where consumers sometimes misunderstand a phrase they hear in automobile advertising: “We’ll pay off your trade no matter how much you owe.”
Yes, the dealership can send a check to your lender and pay off the old loan as part of the transaction. But the dealership did not suddenly become a charitable organization and volunteer to lose $12,000. That negative equity still has to be accounted for. The customer may pay it in cash, or some or all of it may effectively become part of the economics of the next transaction if the vehicle price, down payment and lender’s loan-to-value limits make financing possible.
I spent many years in the automobile business, and I can tell you that getting a lender to approve a deal does not necessarily mean it is a good financial decision for the customer.
Loan approval and affordability are two very different things.
There are several ways people become seriously upside down. Long-term financing is certainly one. Seventy-two- and 84-month loans can make an expensive vehicle look affordable because they spread the payments over six or seven years, but the longer repayment period can leave you owing a lot of money at a point when the vehicle has already depreciated substantially.
Little or no down payment can contribute to it. So can paying too much for the vehicle in the first place, putting a lot of miles on it, having an accident that hurts its value or simply deciding you want another vehicle much sooner than you expected.
But one of the worst ways to create a serious negative-equity problem is to bring negative equity from the last vehicle into the next transaction. Then, a couple of years later, you trade again and potentially carry another shortage forward. Do that repeatedly and you can reach the point where the amount you owe bears very little resemblance to the value of the vehicle sitting in your driveway.
You cannot trade your way out of negative equity. You have to pay your way out of it.
If you find yourself seriously upside down, the first thing I would do is stop shopping. Delete the new-car tabs from your browser. Quit building vehicles online. Stop worrying about what your current vehicle will be worth six months from now. Unless there is a legitimate reason you must replace it, accept that the vehicle you have is probably going to be your vehicle for a while.
That mental decision matters more than you might think. If you spend the next two years constantly looking for some magical deal that will rescue you, sooner or later somebody may show you a monthly payment that looks attractive. That doesn’t mean the negative equity disappeared. It may simply mean the loan got longer.
Instead, attack the problem you already have.
Start by getting the exact payoff amount from your lender and determining a realistic value for your vehicle. Don’t use the highest asking price you see online for a similar vehicle. That is not necessarily what yours is worth. You want a realistic trade or purchase value because that tells you the actual size of the hole. You can always get a cash offer at Carpro.com, just click Sell A Car.
Then look at your loan. Know the interest rate, remaining term and whether there is any prepayment penalty. For most consumer auto loans, extra principal payments can reduce the balance faster, but don’t assume the lender will handle an additional payment exactly the way you intend. Ask how to designate extra money specifically toward principal and verify afterward that it was applied correctly.
Even modest additional principal payments can help. If you can afford an extra $50, $100 or $200 with a payment, send it. A tax refund, bonus or other unexpected money can make a meaningful dent as well. I’m not suggesting emptying your emergency savings to pay down a car loan. Having cash available for an actual emergency is important. But if there is money in the monthly budget that can comfortably go toward principal, that's where I would put it.
While you are doing that, take exceptionally good care of the vehicle.
This is no time to skip oil changes, ignore a warning light or drive around for six months with a strange noise because you don’t want to spend money on the minivan you’re tired of. The vehicle is now part of your financial recovery plan. You need it to remain dependable while the loan balance comes down, and you want to preserve as much of its value as reasonably possible.
There is another temptation I want people to be careful about: refinancing simply to lower the monthly payment. Refinancing can make sense if you can obtain a meaningfully lower interest rate without creating other problems. But if the only reason the payment drops is because you’ve stretched the debt over another five or six years, you may have improved this month’s cash flow while making the underlying problem last even longer.
Always look beyond the payment.
The same is true when you finally start shopping again. I have watched consumers become so focused on maintaining a particular monthly payment that they never stop to ask how much they are actually financing. A skilled finance professional can sometimes structure a transaction to reach a payment target by changing the term, down payment or other variables. That can be perfectly legitimate, but the customer still needs to understand the total amount financed and how long the debt will remain.
There are situations where keeping the current vehicle simply isn’t practical. Maybe it has become unreliable and repairs are overwhelming you. Perhaps an accident totaled it. Maybe a major life change means the vehicle no longer works for your family. If you absolutely must replace a vehicle while seriously upside down, then you deal with the circumstances in front of you and try to minimize the damage. Cash to cover some or all of the negative equity can help enormously. This is also where GAP coverage can matter if a financed vehicle is declared a total loss and the insurance settlement is less than the loan payoff, subject to the specific terms and exclusions of the GAP agreement.
But “I’m tired of it” is different from “I have to replace it.”
That distinction can save you thousands of dollars.
I know my answer wasn’t what my caller wanted to hear. Nobody gets excited when the Car Pro tells them, “Drive what you’ve got for the next few years.” There was no clever financing trick I could give him and no special vehicle he could buy that would make $12,000 of negative equity vanish.
He has an $8,000 minivan and a $20,000 loan. The minivan isn’t his biggest problem. The $12,000 difference is.
Every regular payment reduces it. Every extra dollar properly applied to principal reduces it faster. Time reduces it. Taking care of the minivan gives him the time he needs. As the loan balance falls, eventually the gap should narrow enough that he can begin thinking about his next vehicle without dragging a financial anchor behind him.
What won’t solve the problem is another car deal.
I’ve spent most of my adult life around the automobile business, and sometimes the best advice I can give somebody is advice that doesn’t result in anybody selling a car.
When you’re in a hole, the first rule hasn’t changed:
Stop digging.