- An underwater car loan means you owe more than your car is worth, often because vehicles lose value quickly while loan balances decline more slowly.
- Being underwater on a car loan becomes more likely with long loan terms, small down payments or rolling old debt into a new loan.
- This can become a problem if the car is totaled, stolen, sold or traded in before you build enough equity.
- Gap insurance may help cover the difference after a total loss, and shorter terms or extra payments may help reduce negative equity.
Why You Might Be ‘Underwater’ on Your Car Loan – and What You Need to Know
According to the National Automobile Dealers Association, roughly four out of every five Americans who buy new cars take out loans in order to do so.1 And as soon as you drive it off the lot, the value of a new car drops – depreciates, in industry lingo – and continues to do so over time.
Key Takeaways
Together, those two realities can result in cars being worth less than the balance on their loans. And that could be problematic, especially if the car suffers serious damage in a crash or you want to sell it.
What is an underwater car loan? Simply put, it’s when you owe more on the loan than the car is currently worth.
Why cars can become underwater on a loan
Cars can become underwater on a loan for several reasons, especially when the loan balance goes down more slowly than the vehicle’s value.
| What contributes to an underwater car loan? | Why it matters |
|---|---|
| Rapid depreciation | A new car can lose value quickly, especially in the first year. |
| Long loan terms | More of your early payments may go toward interest instead of principal. |
| Small down payment | Borrowing more up front can put you at risk for owing more than the car is worth. |
| Rolling old debt into a new loan | Negative equity from a previous vehicle can follow you into the next loan. |
Many lenders now offer longer loan terms to help keep monthly payments lower. Some car loans stretch to 72, 84 or even 96 months.
Early in the loan, a larger portion of your payment may go toward interest instead of paying down the balance itself. That can make it take longer to build equity in your vehicle.
Quick takeaway: Being underwater on a car loan isn’t always an emergency if you plan to keep the vehicle for a while. But it can become a bigger issue if the car is totaled, stolen, sold or traded in before you build enough equity.
What to do if you’re underwater on your car loan
It’s not necessarily a terrible thing to owe more than your car is worth, especially if you plan to drive it for a long time. But if you want to trade in your car or get a new loan, you may have some tough decisions to make. You could either pay out of pocket or roll the outstanding loan balance into your new loan, if your lender allows it.
The simplest way to get out of an underwater car loan is to keep the car longer while you continue paying down the balance. There are also ways to reduce the time spent underwater or lower the chances of owing more than the vehicle is worth:
Choose a car model that depreciates more slowly.
Borrow for a shorter term so you can pay down the principal more quickly.
Refinance your car loan. If you refinance your loan at a lower interest rate without extending the term, you can pay down the principal more quickly.
Make extra principal payments to pay off your loan more quickly. If you do this, make sure that your lender won’t hit you with an early payoff penalty.
What happens if your car is stolen or totaled?
One of the biggest risks to being "underwater" on your car loan is in the event the vehicle suffers significant damage in an accident or is stolen. If you have collision or other-than-collision coverage (often referred to as comprehensive coverage) and your car is "totaled," your insurer will pay the current value of your vehicle. Keep in mind, this isn't the original purchase price for your vehicle but rather the current value, which considers any depreciation that occurred after you purchased your car.
Thinking about whether to trade in a car that’s underwater? It helps to understand that the negative equity usually doesn’t disappear. In many cases, it gets paid out of pocket or added to the financing on your next vehicle.
While depreciation happens at different rates for different makes and models, some vehicles can depreciate by 20% or more in the first year alone. If your car is totaled early in your loan term, there could be a gap between what your insurance company pays out and the balance remaining on the loan. This makes you responsible for paying the difference – an amount that could potentially be thousands of dollars. What’s more, this is on top of your car insurance deductible, which will be deducted from the amount your insurer reimburses you.
Gap insurance for underwater car loans
Gap insurance may help cover the difference between your insurer’s payout for a totaled vehicle and the amount you still owe on the loan.
This coverage works alongside your collision and other than collision protection, which is why lenders often require those coverages until the loan is paid off. Gap coverage picks up where your collision and other-than-collision coverage ends, so you need to have collision coverage first. (Most lenders require that you carry both, including collision and other-than collision, until the vehicle is paid off.) It generally covers the difference between the vehicle’s current value and the remaining loan balance, but not debt rolled into the loan from a previous vehicle.
Want details? See “What Is Gap Insurance?” If you’re reviewing your overall protection, “Car Insurance Policies” can also help you understand the coverages that may apply to a financed vehicle.
Weighing your next move? “Selling or Trading in Your Car? Don’t Forget About Insurance Coverage”, “Buying a Used Car: A Checklist to Make It Easier” and “How to Switch Car Insurance Companies” may also help you plan ahead.
Get an auto insurance quote today
FAQs about underwater car loans
An underwater car loan means you owe more on your auto loan than the car is currently worth. This is also called being upside down on your loan or having negative equity.
You may be able to get out of an underwater car loan by keeping the vehicle longer, making extra principal payments, refinancing to a lower rate without extending the term, or paying the negative equity out of pocket when you sell or trade the car.
Yes, you can sometimes trade in a car that’s underwater, but the remaining balance above the car’s value still has to be addressed. Depending on the deal, that amount may be paid separately or rolled into your next loan.
Gap insurance may help if your financed vehicle is totaled in a covered loss and your insurance payout is less than what you still owe on the loan. It doesn’t apply to every situation, so it’s important to review the details of the coverage.
Sources
1 National Automobile Dealers Association
National Automobile Dealers Association
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