What Is an Upside-Down Loan and Why Should I Avoid It?

Posted by on May 12, 2019 @02:53:04 EDT

Car loan Toronto

Despite what image the term conjures, an upside-down loan is not your loan turned upside down! Instead, it refers to a loan that’s greater than the value of the car you’ve just bought. This happens as soon as you sign the contract. Baffling, isn’t it?

It is widely agreed in the automobile industry that a car loses 20% of its value as soon as it hits the road. So, the $15,000 car you just bought would be worth only $12,000 as soon as you take it outside the dealership and start driving it. Why is an upside-down loan bad? Because it will put you at a disadvantage when you want to change your car.

Perhaps, you’d want to dig deeper into what is an upside-down loan and why you should avoid it. If you just nodded your head in approval, then you need to know all the important details about an upside-down loan.

What Is an Upside-Down Car Loan and Why You Should Avoid It

Rolling over and being ‘upside-down’ is great fun for kids and pets. However, the same cannot be said for adults because being ‘upside-down’ generally means that they are in debt. When an adult says they’re upside-down, it generally means that their indebted to an asset far beyond its value. In our case, that asset is a car. For clarity, upside-down loans also apply to homes.

However, it is the car loans that are painting a gloomy picture of the Canadian credit landscape. Automotive News Canada (ANC) reports that according to credit-ratings company Moody’s, negative equity in cars is on the rise in Canada. Negative equity is another way of saying that upside-down loans are dominating the market. ANC believes that the Canadian automobile industry will suffer due to this rising negative equity. This is because more and more buyers will be looking for a used car instead of being in the market for a new vehicle.

An upside-down loan is not just bad for individual car buyers, it is also bad for the automobile industry and the country’s economy. In case you didn’t know already, auto manufacturing contributes $20 billion to Canadian GDP.  So, if sales of new vehicles in Canada are affected by the prevalence of upside-down loans, then there will be a negative impact on the country’s economy as well.

Do yourself, the automobile industry, and the Canadian economy a favor by avoiding going ‘upside-down’ in a car loan Toronto. How can you do that? We’ll discuss that in detail but only after you’ve understood the common scenarios that cause an upside-down loan.

The Scenarios that Lead to an Upside-Down Loan

Bad credit

The feeling that you get from driving around in a new car with a shiny console, leather interior, and fancy cup holders is unrivaled. The only problem is that your car starts to lose its value as soon as you hit the road with it. Moreover, if you bought the car with a loan and have bad credit, then you may soon have to deal with an upside-down car loan. This means that you have accumulated negative equity. In other words, the amount due on your car loan is more than the current value of the car you’ve bought.

Why is this a problem? Because you will be in a catch-22 situation if you get involved in an accident or suddenly need to sell your vehicle. Therefore, you should look to avoid an upside-down car loan Toronto, especially if you have bad credit. The first step in this regard in finding out what leads to an upside-down loan. To make this easy for you, following are some common scenarios that lead to an upside-down loan:

Depreciation

One of the most common reasons for an upside-down loan is depreciation. After they are purchased, cars start to lose their value. This happens on an annual basis and it is the new cars depreciate the fastest. In only the first year of being bought, a new car depreciates by 20%. If you thought that was bad, then the deprecation rate after three years would have you scratching your head.

After three years, your new car will lose 50% or half of its value. At this point, it is easy for the amount due on your car loan Toronto to be greater than the current value of your car, leading to an upside-down car loan Toronto.

Small or No Down Payments

If you secure a car loan without making a down payment or by making only a small down payment, then it means that you’re not very interested in offsetting depreciation up front. In the U.S, the average down payment on a car is 12%. The numbers are more or less the same in Canada. A 12% down payment may be good enough for a used car. However, it won’t cover the 20% loss in value that your new car suffers due to depreciation during the first year of the purchase. This, of course, leads to an upside-down loan.

Long Loans

Long loans refer to loans in which it takes longer to build up equity with a car. To counterbalance the increase in the price of cars, the terms of car loans are also increasing. Today, more than half of new car loans in Canada have 84-month terms. With an increase in the number of buyers getting a car loan with longer terms, the occurrence of upside-down loans in Canada is also increasing.

Roll-Over Loans

This loan occurs when your existing loan’s debt is added to the loan for your next car purchase. When this happens, your total loan amount increases. This leads to negative equity or an upside-down loan if the loan amount due is greater than the value of the new car you’re buying.

Overpaying for a Car

Now, you have one more reason to not overpay for a new car. When you buy a car for an amount greater than its market price, you inflate the loan amount which increases the effects of depreciation.

Add-Ons

This one may surprise you. However, it has been observed that additional features such as rear seat DVDs on or other add-ons like service contract can add up to increase the vehicle’s cost. This can potentially increase the size of your debt.

These common scenarios can lead to negative equity or upside-down  car loan Toronto. You’d think that avoiding these scenarios would help you to avoid an upside-down loan. However, that is easier said than done. This is because there is no way for you to deliberately avoid all of the above situations. Instead, you can avoid getting into trouble by doing a few things that are proven to help avoid an upside-down loan. What are these things? Let’s find out.

The Proven Ways to Avoid an Upside-Down Car Loan

Car loan Toronto

If you’ve already gotten a car loan, then the best thing you can do is keeping paying off the loan until you have ownership of the car or until the amount due is lower than the car’s value. Once you have built equity in the car, it would be less hectic for you to trade in or sell your car when you decide to do that. On the other hand, if you haven’t gotten the car loan yet, you should acquaint yourself with some of the things you can do to avoid an upside-down car loan.

Buy a Used Car and Secure a Good Deal

Compared to new cars, used cars have lesser value. Additionally, used cars depreciate by 11% when they’re taken outside the dealership and onto the road. A decade after the purchase, the car loses more than half of its value. While these rates provide some perspective, they don’t hold true for all used cars. This is because the rates can be lower or higher depending on the popularity of the car being bought.

The more popular a car becomes, the higher its rate of depreciation. Look for a vehicle that still has value. You can look up sites that list used vehicles with their current value for this purpose. Another reason why you should look to buy a used car with a low depreciation rate is that there will be a lower chance of your existing loan being added to the loan for your next car purchase.

Make a 20% Down Payment

As discussed above, one of the reasons for an upside-down car loan is making small or zero down payments. Therefore, by making a 20% down payment, you drive away in a vehicle that is worth more than your loan especially if you’ve bought a used car.

However, that is not the only benefit of making a 20% down payment. You also ensure all taxes and fees are handled properly. When you have to pay interest on such taxes, the abstract fees tend to go higher. Since you get nothing in return for these charges, it is in your best interest to get rid of them as soon as possible.

Apply for a Loan with a Term That Is Shorter Than the Time You Intend to Keep the Car

In Canada, you’d come across many people who change their cars frequently, like every two to three years. Then, there are others who would drive an old Bentley or another classic model for years. Typically, the terms of car loan extend to five years. However, six-year and seven-year terms are also becoming increasingly common. We even have car loans with 10-year terms. This loan would make sense for you if you have a habit of keeping a car until it dies.

However, if you a frequent buyer or if you have an ever-expanding family, then you’d do well to get a loan with a term that is shorter than the time you intend to keep the car. This will allow you to trade in or sell the car while it still has value.

Choose Shorter Repayment Plans You Can Afford

These plans refer to repayment plans with faster payoff and lower interest rates. For example, if you purchase a vehicle worth $20,000 for 3 years at 6.5% interest, then the interest paid on it will be less than what you pay for the same deal over four years. The interest payments will increase in the loan term. Basically, you’d be paying more for the same loan each year. This could ultimately lead to an upside-down loan. How you can avoid this? By going for shorter repayment loans that you can afford.

Get the Best Interest Rate You Can Qualify For

If you have bad credit, then you may want to shop around for the car loan. By actively looking for options online, you’re bound to find a lender that you can get you approved for a car loan regardless of your credit. Additionally, the lender will help you to get the best interest rate you can qualify for. Unlike traditional lenders, online providers of auto loans don’t have shareholders who want higher profits at all costs each year. Therefore, these lenders are more likely to offer you affordable rates.

While the difference in the rates may not that great, the charges add up to thousands of dollars over the term of the loan.  This could be the difference between quickly building equity in the car and being stuck with it due to an upside-down loan.

Final Word

While no one wants an upside-down loan, it can happen. The good news is that you can avoid being in this situation by using the above-mentioned ways that are proven to help avoid an upside-down car loan.

Let's Get Started

Join thousands of Canadians who have trusted AutoLoans.ca.

Get Approved Now