What is an Upside Down Loan?

When it comes to borrowing money, there few things as universally feared as the dreaded ‘upside down loan’. So what is it, exactly, and more importantly, what can you do to avoid accidentally taking one on?

What is an upside down loan?

An upside down loan occurs when the balance left on your loan is greater than the value of the item in question. They occur when the value of the item you’ve purchased decreases faster than what’s left of the remaining loan balance. Simply put, the owner of the item owes more on the item than it’s actually worth.

Some other common terms for an upside down loan are an underwater loan or possessing negative equity.

An Upside Down Car Loan

A car depreciates in value the most in the first couple of years, and if you’re not careful when considering the terms of your car loan, you could wind up owing more on your vehicle than it’s actually worth. For a more clearer idea, if you still owe $12,000 but the vehicle you bought has decreased in value and is now only worth $8,000, then you’re $4,000 upside down.

An Upside Down Mortgage

Most upside down mortgages occur when the market value of the property falls. It can also happen when the property owner gets a second mortgage (meaning they now have two loans out on their home) and the total of the combined loans exceeds the value of the property.

How to Prevent an Upside Down Loan

The key to preventing an upside down loan is to ensure that the length and terms of your loan are reasonable and will not result in you paying out more money in the long run than the item is actually worth. The goal is to make sure that you’re able to get your loan balance to zero before the value of the item does. The best way to do this is to pay off your loan as quickly as you can while staying within your means.

Since new cars tend to lose value the most rapidly, your best bet is to put down as large of a down payment as possible. You want to pay off as much as you possibly can up front so that you shorten the duration of your loan and lessen the total amount owed.

It’s best to make sure your car loan never exceeds 5 years because you run a much higher risk of going upside down. While it’s true that longer term loans can help you keep your monthly payment lower, if you decide to trade in your vehicle early, you run the risk of owing more money on your loan than the actual market value of the car.

Do your best to avoid loans with high interest rates and a long amortization period.

When it comes to buying a home, you’d think it would be considerably more difficult to risk an upside down loan because generally speaking property value increases rather than decreases over time. Unfortunately, the subprime housing crisis (in which people who were not ‘prime’ borrowers were given mortgages with longer terms and much higher interest rates) led to many borrowers defaulting on their loans because they were unable to afford their mortgage payments. This led to home prices falling en masse (causing the value to depreciate rather than increase).

What to Do if You Have an Upside Down Loan

Depending on which loan is upside down, you have different options. For an upside down mortgage, you can look into refinancing or loan modification (here’s a calculator to help crunch the numbers). If you’re able to make your monthly payments and aren’t planning on moving for the foreseeable future, your best option might just be to wait until the market shifts and the value of your property goes up again.

For an upside down car loan, the first step is to figure out exactly how upside down you are (determine the difference between what you owe on the car vs the current market value). As with an upside down mortgage, you can look into refinancing your loan or trading it in for a less expensive car (or one with a rebate incentive). You’ll still have to pay the debt remaining, but you might be able to roll it over into a new loan that is more manageable. Here’s a negative equity auto loan calculator to help you figure out what makes the most sense for you.

Another option is to sell the car. This is definitely a more extreme option, and you’ll have to pay the difference, but it gets you out of the situation almost immediately. Whether you’re able to finance the difference yourself or you have to take out a loan, at least you’ll be on the hook for less than what you owed before.