"Upside-down", "underwater", "negative equity," no matter what you call it, owning more money on your vehicle than its market value is not a desirable scenario. Being upside-down on a car loan poses risks like having to cover the difference in the event of an accident where the vehicle gets totaled. Another concern is if you're not able to make car payments and are forced to sell a vehicle with negative equity. Unfortunately, due to rising car prices, increasing debt, and longer-term auto loans, many car owners are finding themselves upside-down. To avoid the trend, you should plan your vehicle purchase wisely. This means carefully considering the type of vehicle you buy, and how you finance it.
Choose the Right Vehicle
Your vehicle choice plays a large role in managing the risk of being underwater on your car loan. The vehicle segment, whether it's a premium or mass-market brand, and if it's new or used will influence depreciation (the value your vehicle losses over time).
According to iseecars.com, there are some similarities between the highest depreciating vehicles. For example, luxury models outnumbered mass-market brands on the list of the highest depreciating vehicles while passenger cars depreciated more than SUVs and pickup trucks because of higher demand in the latter segments.
KBB's 10 best vehicles for resale value shows a similair trend with only one car (the Chevy Corvette) among trucks and SUVs. It's important to note that SUVs and trucks often come with higher starting prices than smaller passenger cars which results in higher monthly payments and can cancel out the benefit of better resale value.
New vs. Used Cars
According to Nerdwallet, a new car’s value falls 20% to 30% by the end of the first year. From years two to six, depreciation ranges from 15% to 18% per year, and after five years, cars lose 60% or more of their initial value. If your goal is to avoid being underwater, buying a used vehicle is safer than going the new car route. Not only will the purchase price and your loan amount be reduced, but the bulk of depreciation falls on the original owner.
Financing the Vehicle
After selecting the vehicle, the next step to protecting yourself from going upside-down is financing it the right way. This includes finding the lowest possible interest rates, saving up for a down payment, and avoiding long-term loans.
Shop Around for the Best Interest Rates
You'll want to start by finding the lowest interest rates available to you which will allow you to pay more toward the principal and reduce the amount you owe on the vehicle faster. Shopping around for the best interest rates is especially important for car buyers with compromised credit who often end up with very high APR rates or have trouble getting approved for a car loan entirely. Local banks, credit unions, or online lenders are good starting points.
Have a Down Payment Ready
Next, you'll want to make sure you have a substantial down payment saved up to reduce the total amount of debt you take on and eliminate or reduce the amount of time you're upside down on the loan. Since a new vehicle depreciates as soon as it's driven off the lot, without a down payment, you may be upside-down as soon as you make the purchase A 20% down payment for a new vehicle and at least 10% for a used vehicle is recommended, including fees and taxes.
Avoid Long-Term Loans
Car loans are being stretched out longer than ever with 84-month loans becoming more common. If you make it a goal is to pay off the vehicle faster, you'll reduce the chances of going upside-down. Stick with loan terms of 60 months or less on a vehicle that gets you a comfortable monthly payment. This strategy reduces the risk that you'll need to sell or trade-in the car before it's paid off.