Few things are more satisfying than driving your brand-new car – until you realize that it lost value immediately after you left the dealership. Thanks to depreciation, it's possible for a car to lose over 20% of its starting value within the first year. According to CARFAX data, cars can lose over 10% of their value after the first month.
During the early stages of car ownership, it's easy for a car loan to be underwater – meaning that you owe more on the loan than the current value of the car. With a down payment of 20% or less, you're very likely to have an underwater period.
If all goes well, it's okay to be underwater. You'll continue to make payments and the car's value should overtake the remaining loan balance as the balance decreases. Early payments are mostly dedicated to interest and not principal – so it takes time to go from negative to positive equity. As long as you hold onto the car long enough, you should be fine.
What happens when all doesn't go well?
Let's say your car is stolen or totaled in an accident. Standard auto insurance pays you the replacement value of your car – not what your car is worth. You'll be out the difference.
If you must sell your car because you can't make the payments, you probably can't sell the car for enough money to pay off the remainder of the loan. Similarly, if you're buying a new car to replace the underwater one that you're currently driving, you'll have to pay off any negative equity or roll it into your new car loan – putting you automatically underwater on your new car.
Was your credit so poor that you had to accept longer terms or higher interest rates just to get manageable monthly payments? Thanks to greater interest charges, you're likely to be underwater for a longer period and more vulnerable to financial setbacks.
Prevent these potential problems by being underwater for the shortest time possible (preferably not at all).
You can make extra payments against the principal to remove negative equity – if you have enough cash and your lender allows extra payments. Refinancing is another option, especially if your credit score has improved since the original purchase. You can check your credit score and read your credit report for free within minutes by joining MoneyTips.
Large rebate offers on a new car may also get you above water if the value of the rebate exceeds your negative equity – but make sure that the loan term doesn't put you underwater with the new car.
When possible, make your down payment greater than 20% of the car's initial value and keep loan terms relatively short. Shorter loan periods will result in higher monthly payments, but you'll pay the loan off quicker and limit any negative equity.
Avoid financing any add-ons like extended warranties. If you want add-ons, pay cash for them.
Consider gap insurance that covers the difference in your loan balance and your car's value when your car is stolen or totaled. (Remember that gap insurance doesn't apply to a sale or a trade.)
How about a used car? They tend to depreciate at a slower rate, and you can probably afford a larger down payment for a similar car.
Finally, keep your car properly maintained to keep its value – and keep it running as long as possible to decrease the odds of a breakdown. You'll have a hard time selling a functioning car with an underwater loan, but you'll have no luck selling a broken one.
Your credit score influences the interest rate you get on an auto loan. You can check your credit score and read your credit report for free within minutes by joining MoneyTips.