Upside Down Avoid Owing More on your Loan than the Value of your Car

Articles on Loans | Topics: loans, loan, loaning

by Victor Doyle

What happens when you realize that your car is beginning to break down...and you still have more than two years of car payments left before it's completely paid off? This scenario signals one of the most common mistakes people make when buying a car: owing more on a loan than the actual value of the car.

Learning the true costs of your car is one of the greatest things you can do for your financial health. Many people who find themselves in debt don't realize that their car loan is often one of the primary reasons why they find themselves sinking deeper into debt. High car payments mean more and more people are shelling out a lot of money each month on their car loans alone. Because so much cash is being directed to the car loan, more people need to rely on credit cards to make everyday purchases. And this, in turn, makes people sink deeper into debt.

So what can you do to avoid owing more on your loan than the actual value of your car? Simply put, do the math. Before you make your next car purchase, calculate what kind of car and loan would most benefit you in the long run. While 36 months was once the standard loan period, now dealers have extended car installment loans to 60, or even 72 months. By spreading out payments over a long period of time, you are also much more likely to purchase a car you really cannot afford.

While an extended loan term may create the illusion that a car is affordable, in reality you'll end up paying a lot more. The longer it takes you to pay off your car loan, the more interest rates you'll pay. Also, if you still owe $2,000 on your old car, and then buy a new car, the $2,000 will be 'rolled' into your new car loan, resulting in even higher interest rates.

Another unfortunate result of taking on a long-term car loan is that your car will depreciate much faster than you can pay it off. This is the 'upside down' scenario. Cars, especially new cars, are notorious for losing value fast - you've probably heard jokes about how they begin to drop in resale value as soon as they're driven off the lot. If you choose a 60 month loan period, you'll quickly end up owing more on your loan than your car is technically worth.

Quote of the Day

Slight was the thing I bought,
Small was the debt I thought,
Poor was the loan at best—
God! but the interest!

—Paul Laurence Dunbar (1872–1906)

So, besides making sure you choose a short-term loan period, what else can you do to make sure you don't become upside down about your car loan? Be pragmatic about what you can really afford. It is easy to succumb to impulse when purchasing a car. Next time you go to the dealership to browse, be armed with cold hard figures. Financial experts have a formula to determine how much you should be spending on your car purchase. Simply multiply your monthly take-home pay by 0.15. This is roughly 15% of your monthly income. Your car payment should not be much more than this figure. For example, if your monthly take-home pay is $3000, your monthly car payment should not exceed $450.

While this is a good start, you must also look beyond the sticker price. Research your top picks carefully. What are insurance costs like for specific makes and models? What type of repair costs might a certain car demand? What kind of fuel economy does it get? Make sure to calculate these figures into the final cost.

Another easy way to avoid becoming upside down about your car loan is to avoid buying a new car. The value of a new car depreciates rapidly in the first two years, often by as much as 30 to 40 percent. Why not let someone else pay for this fast depreciation? If you must absolutely buy a new car, hold on to it for a few years. This will allow you to absorb those extra costs.

When it comes to buying a new car, be smart. Do the math - don't get caught in the upside down dilemma. Buy a car (preferably used) that you can afford to pay off in a relatively short (32 month) period.

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Please note: All personal opinions expressed in the "Upside Down Avoid Owing More on your Loan than the Value of your Car" article belong to the contributing author and are not necessarily shared by LoansCreditConsolidation.com.

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