As the title of my website indicates I advocate driving a car purchased with cash. I believe this gives individuals an opportunity to prioritize their spending. The focus can then be on their financial future rather than living for the car of the day.
Having said that, I know I am in the minority. Most people buy cars on credit. The result is many people find themselves in a car loan that is underwater. You may also hear this being called upside down or having negative equity. Let’s take a look at what being underwater is and how it can happen.
An underwater car loan is one in which the loan balance is more than the current value of the car.
An example is you owe $20,000 on a car worth $18,000 you would have negative equity of $2,000. This is being underwater. Meaning if you sold the car for what it is worth you would owe $2,000.
How can this happen you might ask?
Let’s start with new car prices continuing to go up while wages have fallen. Both Truecar.com and KBB.com show new car prices over $31,000 in the month of August. This is up from just over $28,000 in 2009, as sited in an article by the Detroit Free Press.
While the mean salary in the U.S. has gone from $54,500, in June 2009, to $52,100, in June 2013, according to an August article in the New York Times.
Between 2009 and today, wages are down almost 5% while new car prices are up nearly 11%. These numbers create a problem for the auto and lending industries as well as consumers wanting to buy a new car.
How could more expensive cars be sold to people with less money?
The answer, by lengthening the loan term for new car financing. By doing this it will keep new car payments from going beyond a buyer’s ability to pay. People who believe they will always have car payments tend to focus on the car payment as the sole definition of affordability.
According to the Wall Street Journal, 17% of all new car loans in the first quarter of 2013 were between 73 and 84 months. In 2009, only 11% of loans fell into this category. The result, more people financing larger amounts over a longer period. This has led to more car loans being underwater.
I have utilized new car purchases to illustrate how people have gotten in to underwater car loans, but similar factors exist in the used car market too. Since used cars have already lost much of their value in the first few years, however, this is less of an issue.
Underwater car loans can also be created by rolling negative equity from a previous car purchase into the purchase of ones current car. This happens quite often when people are trading up after having owned a car for a short period of time.
There are other ways an underwater car loan situation can be created, but I think I have given enough examples to explain being underwater and how people can find themselves in this position.
If you find yourself in an underwater car loan situation, what can you do?
1. Keep making the payments.
If you can afford to do so, continue to make the payments.
Make the payments until you pay your car off. You are now driving a cash car. You can then save the car payments you were making to buy you next car.
Alternatively, you can continue to make payments and drive the car until you can get to a positive equity position. You would want to continue making payments until you have enough equity to buy your first cash car. You can then sell your debt laden car. The benefit of this alternative strategy is it allows you to get to a cash car more quickly.
2. Take out a personal loan and sell the underwater car.
This option requires you take out a loan for the amount you owe over and above the car’s sale price. This can be done in one of two ways.
The first, is to go to the financing company for your car and see if they will agree to allow you to take out a personal loan for the difference between the sales price and the amount financed.
The second, is to go to your local credit union or bank and secure a personal loan for the difference between the car’s value and loan payoff.
Regardless of which option you choose, be sure you secure an agreement for this financing before you sell your car. You will need to pay off your current car loan when you sell your car.
The benefit of selling versus trading in is selling will allow you to close more of the negative equity gap.
A quick personal story to illustrate the point. I have never traded a car in, but tried to once. I had a car that was quite old and I didn’t think there would be much difference. The dealership offered me $600 for the car. I had researched the car’s value and knew the trade in value was $1500. I rejected their offer and their car. I sold my car for $2800 and bought somewhere else.
With your underwater car sold, you can now focus on getting a more affordable car to drive. As you likely haven’t been able to save enough for a cash car you will still need to buy a car using credit however.
3. Trade down and roll the negative equity into the new loan.
For this option, let’s assume you have a $25,000 loan and your car is worth $23,000 if you sold it. Let’s say you find a used car you like for $12,000. If you can trade in your existing car for $21,000 and finance the additional $4,000 on the used car. The new loan on the used car worth $12,000 would be $16,000.
You might be saying what is the benefit, I am still upside down and even more in the hole. The benefit is you were in a loan of $25,000 and now you are in a loan of $16,000. You just eliminated $9,000 in auto debt. Another benefit maybe a lower monthly payment depending on the financing on the current car and financing on the used car.
I will be the first to say this is not an ideal solution. It is, however, another option to consider. You maybe having trouble making your payments. You may want to eliminate as much auto debt as you can as quickly as possible.
If you are underwater on your current car, you have my sympathy. I haven’t had this happen to me, but I have been in a situation where I needed to sale a car but couldn’t. Feeling trapped is an awful feeling. You now know you have options.
I hope one or more of the options will help you get out of your underwater car. It will be a step in the right direction. A step towards a cash car and getting control of your financial future.
What car issues are keeping you up at night? Let me know and I will try to address it in a future post.
Question: What is keeping you from buying a cash car? If you already drive a cash car. How did you get the money to purchase it.