What Are "Upside Down Car Loans?"
If you are upside down in a car loan, it means that at that given point in the loan repayment your automobile is worth less than what you owe on it.
In other words, if you sell your vehicle at a point when you are upside down in the car loan, you would have to come up the cash to pay the difference between what the car sold for and what you still owe on the car. Otherwise, the auto finance company won't clear the title so you can legally sell the automobile.
What Causes an Upside Down Loan?
The first thing you need to be aware of when purchasing a car is that cars depreciate (drop in value) faster when they are bought new than when they are bought used (see the Car Depreciation Calculator).
For example, if you buy a new car, you can expect it to drop in value by as much as 40% in the first two years of ownership (up to 20% of which occurs the moment you sign the papers!).
On the other hand, if you buy a used car that is two years old, it may only depreciate by 20% in the first two years of ownership. If you buy a used car that is ten years old, it may only depreciate by 5% in the first two years of ownership.
Now, what gets people into trouble is when they purchase a new car with little or no down payment. The trouble is, the moment the buyer signs the papers the new car value drops by as much as 20%, while the freshly crafted car loan balance is equal to 100% of the new car's price (or more if you wrap sales taxes and fees into the loan).
Finally, because the average person fails to budget and account for all of the costs of buying and owning an automobile (see the Car Buying Calculator), or because their income takes an unexpected drop, many people suddenly find themselves unable to afford the new car they purchased. But, because they are upside down in the car loan, they can't just sell the automobile to get rid of the expenses they can't afford.
You know what happens then, don't you? Well, first the auto finance company repossesses the automobile. Second, the owner is still responsible for the difference between what the automobile is worth and the amount of their loan. And third, because their credit rating took a big hit from the repossession, the next time the consumer goes to buy an automobile they will be forced to pay a painfully high loan interest rate.
As usual, the buyer's loss becomes the auto finance company's gain.
Reality Checks
Before you sign on the dotted line, visit the used car section of the dealer lot and locate a 3-5-year-old version of the new car you are considering buying.
Take a good look at the car and ask yourself if you will still be happy to be making the new car monthly payment once the new car turns into the used car you are seeing.
If your answer is "no," you might consider buying the used version of new car and spending some time thinking about how you might invest the thousands of dollars you will be saving (30% to 60% of the price of the new car!).
If you're still not moved to reconsider buying a new car instead of a used car, visit the local auto salvage yard and while looking out over the vast array of junked automobiles, ask yourself how many people bought those cars "new" because they thought the shiny new cars would make them happier.
Finally, if you do decide to buy a new car instead of a used, plan to own the car for at least ten years to get your money's worth. And be sure to continue making your monthly car payment to yourself ("next car" savings account) once the car is paid off. That way you may be able to pay cash for your next car and save yourself thousands of dollars in interest charges.