What It Means To Be Underwater On A Loan And How You Can Start To Swim

One of the key benefits of buying a car with cash is you have complete ownership over that vehicle. Naturally, cash purchases are much easier when buying an inexpensive car from Craigslist or Marketplace, but consumers looking at new or lightly used models often don’t have tens of thousands of dollars at their disposal. Therefore, they need to take out a loan. Despite what some “financial gurus” would have you believe, borrowing money to pay for a car is not a bad thing, but it can put you in a difficult financial situation if you aren’t careful. Far too many buyers have found themselves underwater on their car loans — especially recently on EVs that have depreciated like rocks. Here is what that means and some ways to manage it.

[Writer’s Note: “Hello friends and fellow enthusiasts! Many of you remember me from “other websites” as the guy who gives practical car-buying advice. I’m happy to be helping my pals here at The Autopian as a contributor. My goal is to have a regular column where you ask me car buying conundrums/questions and I answer them. Send me your messages with the subject – “Autopian Car Buying” to Tom@AutomatchConsulting.com !]

Being underwater on a car loan means that your loan balance is greater than the market value of your vehicle. This is also known as having “negative equity.” For example, let’s say someone purchased a Nissan Rogue with an MSRP of $32,360. After their local sales tax and DMV fees were factored in, they had a total purchase price of $35,500. They financed this vehicle for 72 months at an interest rate of seven percent and didn’t put any money down, resulting in a payment of $605 per month. A year goes by, and this person decides they want to upgrade to a bigger car. Their current loan balance sits at $30,565, but their trade is valued at only $25,500. That puts them about $5,000 underwater.

Those who bought electric cars are facing an even more dire situation due to the accelerated nature of EV depreciation. I’ve spoken with folks who want to trade in their EV only to find out that the delta between the market value and the loan balance is upwards of $10,000 or more. If you find yourself in a situation where you are underwater, here are some options.

Hold On To What You Have

For most people, this is the best option. Being underwater only really matters if you are trying to sell or trade your car. The longer you keep what you are currently driving, the more usable value you can extract from it, and eventually, you will reach a point where there is an equilibrium between the market value and loan balance. Buyers should look honestly at their situation and determine if they really need to get another car or just want another car.

Perhaps your current ride is becoming an unreliable nightmare, or you have a growing family and can’t fit the kiddos into something small. If you determine that it’s critical that you need to move into something else, choose your next move carefully.

Bring Some Cash To The Table

If financing another car is what you need to do, bring cash to cover the gap between the value and the loan balance. While this is the most obvious solution, it is often the most ignored. Using the Nissan Rogue example above, if that buyer wanted to finance another car they should put at least $5,000 down (ideally more) so that the next loan is only for the replacement car.

Unfortunately, in today’s economic climate, too many people simply don’t have thousands of dollars in extra savings. If that’s the case, you may need to get creative

Try Leasing

A possible way to break the underwater cycle is to roll your negative equity over into a lease. Since leases often offer payments substantially lower than finance programs, and end at a fixed term, you can use the lease to “break the cycle” of the underwater situation.

Here is how this could play out in the case of the custom with the Nissan Rogue with $5,000 in negative equity. If this person was looking for something bigger with three rows, they could explore the Hyundai Santa Fe with a current lease special of $329 per month for 36 months with $3,999 due at signing (before tax). As I mentioned above, this person likely doesn’t have several grand to bring to the table to neutralize some or all of the negative equity, which means they need to roll both the $3,999 down payment and the $5,000 in negative equity into the lease. This would increase the base payment by about $250 and they would be looking at a total payment of about $580 per month (before tax). This is within the ballpark of their original loan of $605 per month. While they will not have any equity in the Santa Fe at the conclusion of the lease, they would be able to start fresh.

This is an area where leasing an electric vehicle can be extra beneficial since the lease programs offer super low payments compared to the sticker price, and the massive rebates and discounts can absorb most or all of the negative equity. However, due to mileage restrictions and other factors, leases don’t work for everyone. In that case, there is one more option.

Roll It Over Into Another Loan

If using cash to neutralize the negative equity isn’t available, and a lease won’t work, the absolute last resort is to take a loan out on another car and roll the negative equity over into that loan. Let me be clear, this doesn’t actually solve the problem of having negative equity and will often compound the underwater situation. All this solution does is allow the buyer to change vehicles, and they will likely have a higher payment.

Going back to our example of the Nissan Rogue with $5,000 in negative equity, if this person were to buy (instead of lease) that Hyundai Santa Fe SE with an MSRP of $35,775, maybe they will qualify for the 2.99 APR special for up to 72 months. Then they would be financing a total of $40,775 (before tax and fees) for a payment of $619 per month. That doesn’t seem too bad compared to the original payment on the Rogue of $605, but if this buyer’s credit score doesn’t qualify them for the low rate, and they are back at that seven percent interest rate, the payment jumps to $695 per month.

If you must rollover your negative equity into another loan, take the shortest loan term possible and shop around to find the lowest interest rates you qualify for. Also, plan on keeping this car for as long as you can, ideally well past the point at which it is paid off.

How To Avoid Being Underwater

Having negative equity is often a situation where an ounce of prevention is worth a pound of cure. There are a few key ways to avoid being underwater. First, use a sizable down payment. The more money you can bring to the table, the lower your principal balance and therefore the less chance of you being underwater because the value of the car will be greater than the loan balance. Second, choose models that retain their value. Brands like Honda and Toyota have narrow depreciation curves and retain value. Therefore, these models are likely to keep you in a positive or neutral equity situation. Third, don’t stretch your loan too far. For most people, the sweet spot for getting a desirable model with reasonable monthly payments is a 60-month term. With a hefty down payment, you can stretch as far as 72 months, but if the only way to “afford” your target car is to take out an 84 or 96-month loan, I would suggest looking at something cheaper to avoid the danger zone of negative equity.

Top graphic images: Nissan; depositphotos.com