Consumers trading in their car for new wheels can get a nasty surprise: Their trade-in is worth less than what’s due on the auto loan.
When that happens, they’re “upside-down” or “under water” on their car loan, which Christi LeNarz, 34, understands all too well.
LeNarz has a 1998 Toyota Camry with a trade-in value of no more than $5,000, but she owes $10,000 on her loan.
“I would love to have a new car,” LeNarz says. But with any car purchase, “I’d continue to be upside down.”
LeNarz isn’t alone.
The problem is especially prevalent in status-conscious areas such as Orange County, Calif., says Jack Nerad, executive auto analyst at Kelley Blue Book, a source for used-car values. “Keeping up with the Joneses implies new cars often, but frequently the loan terms mean that consumers are upside-down when they go to trade,” he said.
It’s easy to find yourself in this position, particularly when you’re at the dealership and feel you must have that new BMW 525i sedan right now.
But you don’t have to put yourself under water. Here are some tips to keep you right-side up in your vehicle:
Figure out what you have.
Many consumers have no clue about their financial position – until they go to trade in their car. But it’s easy to figure out if you’re under water, and – in car-speak – have “negative equity” in your trade-in. Get the current value of the car (from online sources such as Kelley Blue Book or www.Edmunds.com) and compare it with what you owe on your loan. This gives you a rough estimate of your position. If you owe $10,000 on the car and the trade-in value is $12,000, you’re OK. If it’s the reverse, you’re upside-down.
Don’t roll one debt into another.
This is what happened to LeNarz. She rolled a lease buyout into the purchase of her Camry. That move put her under water in her loan quickly. “It’s a snowball that keeps going if you let it,” says Phil Reed, consumer-advice editor at Edmunds.com. He and others advise consumers to pay off the original debt first – in this case the lease – before taking on another loan.
Make a decent down payment.
Low or no down payments may sound good up front, but it’s a poor strategy that hurts consumers in the long run. Reed advises buyers to try to put 20 percent down on a car purchase so they are not caught upside-down in the first few years. (Kelley Blue Book figures show that 65 percent of car buyers put down less than 20 percent.) The down payment essentially prepays the first year’s depreciation, which is very steep. This puts you in the position of always having equity in the vehicle. Consequently, you have the freedom of trading it in at any time without taking a loss, he says.
Watch the loan period.
Make your loan period coincide with the time you think you will be comfortable owning that car. If you intend to buy another car in three years, don’t take out a loan longer than that term. Consumers are extending their loan terms from what was once a three- or four-year term to five, six – even seven – years. There’s no harm in being upside down in your loan if you decide to keep the car through the end of the loan term. In fact, because a car depreciates rapidly in the first two years of ownership, many consumers might be under water on their loan at that point, without even knowing it.
“The challenge arises when the consumer decides she or he wants to acquire a new vehicle during the loan term – say in the third year of a six-year loan – and discovers that she or he owes more on that car than it is worth,” Nerad says.
Don’t buy too soon.
Simple, but true. Pay off what you owe on the vehicle, and don’t go shopping until you can afford a new car, Reed says. This takes some patience and hard work. Put every cent toward paying off your car loan. When Heather Mora, 22, visited a dealership to trade in her Nissan Altima, she realized she was so upside-down in her loan that she walked out – with her Altima – and mailed in a hefty $3,000 toward her car loan. Now she owes $11,000 and intends to pay it off before getting another vehicle. “I don’t want to put myself in a deeper hole.”
Use incentives.
Some consumers may be close enough to paying off their loan that the incentives many manufacturers are offering can help. Here’s how, according to Reed: You owe $1,500 on your car loan. The manufacturer is offering a $3,000 rebate. Use half to settle your old auto loan and the other half as a down payment.
Refinance your current loan.
This doesn’t mean you can rush out and buy your new car. Refinancing is a strategy to help accelerate your payments and get out of your old car loan. For example, if you have a five-year loan at 12 percent and are halfway through that period, refinancing is a good option, Reed says. You may qualify for a lower rate. If you’re really itching to get out of the loan, double up on the payments.
Tap a home-equity line of credit.
This one comes with a giant caveat. An advantage of paying off an auto loan with a home-equity line of credit is that you can write off the interest from the home-equity line on your tax return. And you might get a better interest rate. But don’t max out the line of credit, and – this is the most important part – you should forget this idea entirely if there’s any chance you won’t be able to make your home-equity payments. “It’s not worth risking your house,” Reed said.
Shop around.
Do your homework when buying a car. Some models hold their value better than others. For example, Edmunds researchers say a Honda typically holds its value better than a Mitsubishi. Also, some consumers say they’re under water because a dealer offered them a lot less for their trade-in than what it was worth. If negotiating with the dealer for a higher offer fails, take your business elsewhere and try again. You’re not obligated to take offers that you don’t think reflect the value of your trade-in. You can always sell the vehicle yourself.
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