Make sure your car loan isn’t “underwater” before you trade it in

The automobile is recognized worldwide as the classic symbol of status in America. The long roads in this country and our relative distaste for mass transit make the car the ideal method of transportation for most Americans. When you spend as much time in your car as most Americans do, you tend to express yourself through your choice of automobile. Because of this, Americans tend to buy cars more often than people in other countries, and probably more often than is economically sensible. 

The payment for a car is usually the largest single household expense each month after the house payment. Years ago, when the average car was more affordable, the typical term of an auto loan was two or maybe three years. But cars have increased in complexity and price, and the prices have increased faster than inflation or salaries. The typical auto loan now runs five years, and loans of up to eight years for luxury cars are not unknown. The problem with a loan that runs from five to eight years is that few buyers keep their cars for that length of time. The urge to drive something new, the urge to keep up with the neighbors and the urge to have the latest, greatest car on the block usually inspires people to trade in their cars every two to three years.

This has led to an interesting situation. Last year, the average car loan was issued for an amount that averaged 101% of the car’s price. How can that be? Many car owners are trading in their cars while they still owe money on them. Worse, they are trade in value is less than they owe on the car! Most cars experience a 50-75% drop in value during the first five years, with the most dramatic decrease coming in the first year. If you have a five year car loan and you trade in after two years, your loan is said to be “underwater”; you still owe more than the car is worth. The dealer will tell you that it’s OK; they’ll give you a trade in on your car, roll the amount you still owe into a new loan, and you can finance the whole thing. What’s wrong with using a debt consolidation loan on a car? The bad situation is now worse; you owe more than the car is worth before you even take delivery! Should you be involved in an accident that renders the vehicle a total loss, your insurance will only repay the replacement value of the vehicle. You could end up with no car and a lot of debt.

Here are some ways to avoid this scenario:

Keep the term of your auto loan as short as you can reasonably afford. If you want a Viper but have to pay for seven years to manage the payments, you should probably be driving a Honda. If you aren’t sure that you’ll have the car for more than 3-5 years, then keep the loan to that length or less.

Put more money down. The more you pay upfront, the less you’ll have to finance. That minimizes the risk of being underwater.

Keep your car until you have fully repaid your loan. In fact, drive it until it won’t run anymore. That’s the most cost-effective way to own a car.

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