When you walked into the dealership, you fell in love with your current car. It was so shiny and new.
Five years later, you’ve fallen out of love with your gas-guzzler with the thread-bare tires and are wondering if you could just trade it in for the next beauty.
Then you remember you still owe on your current hunk of junk. And that to get monthly payments low enough for you to afford your current car, you jumped at the six-year (or seven-year… or eight-year) term the dealer offered.
You’re not the first person to fall for a set of wheels that’s beyond reach, especially as car loans have continued to climb. The average loan amount for a new vehicle was $37,746 in the third quarter of 2021, according to Experian.
To offset the cost, more people are lengthening their loan terms to lower their monthly payments. In fact, the 72-month car loan is now the most popular car loan option, with the 84-month loan coming in second, according to Edmunds. For the non-mathletes among us, that’s a six- or seven-year car loan.
Then consider that new cars lose 20% of the value the moment you drive them off the lot and depreciation accounts for more than a third of the average annual cost to own a car, according to AAA.
All of those factors combine to create the scenario where you owe more than your car is worth, which means you have negative equity in your loan — aka, your car loan is upside down or underwater.
Unfortunately, there’s not much use staring in the rearview mirror at this point about what you should have done with your old car’s loan, but you still have options to recover — it’s just a matter of making smart financial decisions.
What to Do If You Have an Upside-Down Car Loan
Before we get ahead of ourselves, are you sure your vehicle is worth less than what you owe? Let’s run the numbers.
How to Calculate Your Car’s Equity
Here’s how to calculate the equity in your vehicle:
Value of your vehicle – loan payoff amount = equity
Each of the price guide websites may vary in the estimate for your car’s value, so check with all three and then use the average number for the value of your vehicle.
When figuring out how much you owe on the loan, use the loan payoff amount and not the principal, as the payoff amount may include things like fees and taxes you still owe on.
So if your car’s value was $18,000 and your loan payoff was $15,000, you’d have $3,000 in positive equity. Yay! If you want to trade in your car for a newer one, the dealer should apply that $3,000 toward your down payment, thus reducing the overall amount you pay for your next car. Congrats!
However, if your car’s value was $18,000 and your loan payoff amount was $20,000, you’d have $2,000 in negative equity — you owe more on your car than it’s worth. Sorry.
But that’s why we’re here, so let’s look at your options and get you on the fast track to financial freedom.
How to Trade in a Car With Negative Equity
Stuck with an underwater car loan on a vehicle that you need to unload? Then let’s start with the worst idea and work our way up.
1. Roll Over the Amount You Owe Into a New Auto Loan
If you’ve heard or seen any dealership ads that promise to pay off your loan and put you into a new car, you may be thinking what a great idea it is. Well…
“This is a terrible idea, but it’s an option, and a lot of people take it because it seems easy, but it makes things worse,” said Todd Christensen, AFC and Education Manager at moneyfit.org. “It makes it even harder to get out of debt.”
If you get in an accident and the car is totaled, the insurance company will pay for the value of the car, not how much you owe on it. Consider buying gap insurance to cover the difference.
That whole promise to pay off your loan isn’t exactly accurate, according to the FTC — the dealership will pay the bank to satisfy what you owe, but they’ll add that amount to your next loan or subtract it from your down payment.
And maybe they’ll tack on a fee, just for good measure.
And because the dealer had to finance the remainder of your old loan plus the new one because you couldn’t pay off the first — thus making the new loan riskier — you can also expect to pay a higher interest rate.
And adding your negative equity to your new loan amount probably puts you underwater on the next car loan as soon as you sign the papers. So the vicious cycle continues.
It all adds up to a bad idea.
But if this is your only option, Chistensen did suggest ways you could minimize your next loan:
Downsize to a cheaper car. If you’re currently paying for a half-ton pickup and can rollover your loan into a midsize sedan, you could be looking at a smaller payment even after adding the underwater debt amount into the new loan. Also, skip the premium package.
Apply for a shorter loan term. You’ll pay more per month, but if you agree to a five-year loan instead of taking the seven-year term, you’ll pay less in interest in the long run and it helps reduce the chances you’ll end up with another underwater loan.
Look for cash-back offers on the next car. If the rebate is large enough, you might be able to use it to pay off the negative equity on your old loan.
Get a loan preapproval. Shopping around for a preapproved auto loan for your new loan potentially helps you snag a lower interest rate than the one a dealership would offer.
None of these options will absolutely prevent you from starting out underwater on your next car loan, but they can help reduce the time you’ll spend climbing out of the hole.
2. Roll Over Your Underwater Car Loan Into a Lease
Although leasing a car means you won’t own the vehicle, you can benefit from the fact that you don’t have to keep paying down negative equity when you reach the end of the lease term.
“I rarely recommend leasing a vehicle, but this would often be a better idea than rolling over your negative equity into your next car loan,” Christensen said. “It makes their lease payments larger — that’s obviously a negative — but on the positive side, they don’t have to worry about being underwater with a lease.”
3. Pay Down the Negative Equity
Paying down the negative equity on the car as quickly as you can is better than the first two options because you’re actually helping yourself get out of debt instead of just passing it through to your next payment.
If you have the cash to pay off the negative equity, that’s an obvious choice, but you can also consider picking up a side job or temporarily cutting personal expenses — you could even get paid to drive your car and let the old hunk of junk earn its keep.
Use every extra dollar you make to pay down the debt and get your car loan back above water before you trade it in for the next vehicle.
4. Sell the Car Yourself
You know how #1 on our list was the easiest (and least financially savvy) option? Here’s the hardest way to get yourself out of your underwater car loan, but it could also be among the most lucrative: Sell the car yourself.
The payoff for the extra effort could be worth your time as opposed to trading it in at the dealership. Christensen noted that the difference between selling on your own instead of settling for the trade-in offer could be the difference of a couple thousand dollars, depending on the car.
If you know someone in your network of family, friends and coworkers who’d like to buy the car, it makes the process of selling a little easier. Otherwise, you’ll need to advertise the car and sort through prospective buyers who’ll probably want to schedule a test drive. And you might need to head to the bank to transfer the title since you still owe on the car.
5. Hang Onto Your Car
This, in the end, is the best option, financially speaking. If you can hold onto your car not only until you get out of water, but for years after you have the loan paid off, you can put your former car payments into a separate account and build up a downpayment — or maybe the whole payment — for your next car.
Yes, it isn’t always an option — especially if your current car needs pricy repairs — but you should at least weigh the cost of repairs vs. the long-term financial benefits of holding onto your old wheels.
It might not be the new wheels you’ve been dreaming of, but it does put you in the driver’s seat for your financial future.
Tiffany Wendeln Connors is deputy editor at The Penny Hoarder. Read her bio and other work here, then catch her on Twitter @TiffanyWendeln.