Being underwater on your car loan can feel like you’re sinking financially, but you’re not alone. According to the Federal Reserve Bank of New York, auto loan balances increased by $10 billion to reach $1.63 trillion in the second quarter of 2024. 

Many Americans owe more on their vehicles than they’re worth. But don’t lose hope—there are actionable steps you can take to navigate this financial challenge.

Understanding an Underwater Car Loan

Being “underwater” on your car loan means you owe more on the loan than your car’s current market value. This negative equity situation can be a significant financial burden, especially if you want to sell or trade-in your vehicle. 

The first step is acknowledging the issue and understanding how you got here.

How Do You Become Underwater on a Car Loan?

Let’s break it down with some real-world examples:

• Minimal or No Down Payment: Suppose you purchase a new car priced at $30,000 but put zero money down. The moment you drive off the lot, the car depreciates—typically by about 20% in the first year—reducing its value to $24,000. However, you still owe the full purchase price minus a few payments, immediately placing you in a negative equity position.
• Extended Loan Terms: Imagine financing that $30,000 car over seven years (84 months) to keep monthly payments low. While this seems affordable monthly, the car depreciates faster than you’re paying off the principal. After three years, the car might be worth $18,000, but you still owe around $22,000.
• High-Interest Rates: If your credit isn’t strong, you might have an interest rate of 14% or higher. A significant portion of your early payments goes toward interest rather than principal, slowing down equity buildup. For example, on a $25,000 loan at 14% interest over 72 months, you could pay over $12,000 in interest alone.

The Depreciation Dilemma

New cars typically lose 15-25% of their value each year during the first five years. Let’s consider Emily, who bought a new sedan for $35,000 with a minimal down payment and a six-year loan term. After two years, the car’s value drops to $25,000 due to depreciation. Emily still owes around $29,000 on her loan. If she needs to sell or trade in the car, she’s $4,000 underwater.

Life Changes and Negative Equity

Life is unpredictable. You might have bought an SUV for your growing family, but circumstances change:

• Job Loss: Mike financed a truck for $40,000 but lost his job six months later. Needing to cut expenses, he tries to sell the truck, only to find it’s now worth $35,000 while he owes $38,000.
• Relocation: Sarah moves to a city with excellent public transportation. She decides to sell her car but discovers she’s underwater by $4,000, complicating her plans.

The Financial Impact

Being underwater can have several repercussions:

• Limited Options: Trading in or selling the car requires you to cover the negative equity out of pocket or roll it into a new loan, increasing your debt burden.
• Insurance Shortfalls: If your car is totaled or stolen, standard insurance only covers the car’s current market value. If you’re underwater, you’re still responsible for the remaining loan balance. For instance, if your car is worth $20,000 but you owe $25,000, insurance will pay out $20,000, leaving you to pay the $5,000 difference.
• Credit Risks: Falling behind on payments because the car feels like a bad investment can lead to loan default, damaging your credit score and financial future.

Why So Many Are Underwater

The surge in auto loans isn’t just a statistic; it’s a reflection of consumer behavior and market trends. Extended loan terms, minimal down payments, and rapid vehicle depreciation contribute to negative equity. When you finance a car with little to no money down and stretch the loan over six or seven years, the vehicle depreciates faster than you’re paying off the principal.

Assess Your Financial Situation

Before making any decisions, take a hard look at your finances:

• Calculate Your Negative Equity: Determine exactly how much you owe versus your car’s current value. Websites like Kelley Blue Book or Edmunds can help you find your vehicle’s market value.
• Review Your Loan Terms: Understand your interest rate, monthly payments, and how much longer you’ll be paying.
• Check for Prepayment Penalties: Some loans charge fees for paying off the loan early.

Options to Consider

1. Keep the Car and Pay Down the Loan Faster

Sometimes the best option is the simplest: stay the course but accelerate payments.

• Make Extra Payments: Allocate any extra funds toward your principal balance to reduce the loan faster.
• Refinance for a Shorter Term: If your credit has improved, you might qualify for a better interest rate or shorter loan term, helping you build equity more quickly.

2. Refinance the Loan

Refinancing can lower your interest rate and monthly payments.

• Improve Your Credit Score: A higher credit score can secure better loan terms.
• Shop Around: Compare rates from multiple lenders to find the best deal.

3. Sell the Car Privately

Selling your car yourself can fetch a higher price than a dealer trade-in.

• Use the Proceeds to Pay Off the Loan: You’ll still need to cover any remaining balance out of pocket.
• Consider a Personal Loan: If you can’t cover the difference, a personal loan might have a lower interest rate than your car loan.

4. Roll Over the Negative Equity

While not ideal, you can roll the negative equity into a new car loan.

• Proceed with Caution: This can lead to a cycle of debt if not managed carefully.
• Choose a Less Expensive Vehicle: Opt for a car that won’t add significantly to your debt load.

5. Voluntary Repossession

As a last resort, you can surrender the car to the lender.

• Understand the Consequences: This will severely impact your credit score and remain on your credit report for up to seven years.
• Consult a Financial Advisor: Explore all other options before taking this step.

Preventing Future Negative Equity

Once you’ve addressed the immediate issue, focus on long-term financial health:

• Make a Larger Down Payment Next Time: This reduces the loan amount and initial negative equity.
• Choose a Shorter Loan Term: Aim for loans of 48 months or less to pay off the principal faster.
• Buy a Reliable Used Car: Used cars have already undergone significant depreciation, reducing the risk of negative equity.

Changing Your Mindset

Don’t fall into the trap of believing that owning a new car is a necessity. A vehicle is primarily a means of transportation, not a status symbol. Adjusting your expectations can save you thousands of dollars.

The Role of Insurance

Gap insurance can protect you if your car is totaled while you still owe more than it’s worth.

• What Is Gap Insurance? It covers the “gap” between your car’s value and the amount you owe on your loan.
• Is It Worth It? If you’re underwater, it can prevent further financial strain in the event of an accident.

Take Control of Your Financial Journey

Being underwater on your car loan isn’t a life sentence. By taking proactive steps and possibly adjusting your lifestyle, you can regain control of your finances.

• Create a Budget: Know where every dollar is going to manage your finances more effectively.
• Build an Emergency Fund: This prevents reliance on loans for unexpected expenses.
• Seek Professional Advice: Financial planners can offer personalized strategies tailored to your situation.

The Bottom Line

Owing more on your car than it’s worth is a challenging situation, but it’s not insurmountable. By understanding your options and making informed decisions, you can steer yourself back to financial stability. 

Remember, the goal isn’t just to get out of a bad loan—it’s to set yourself up for long-term financial success.