Friday, January 5, 2007

The View is Lousy from Here -- fixing upside-down car loans

Many of you may have read my November 19, 2006 post, Paying Cash for Your Car and said, “yea right, but what if you already have a vehicle and are upside-down with the loan?”

For those of you lucky enough to have never heard that term, “upside-down loan” is the politically correct term for owing more than what the vehicle is worth. You may not have heard it because you are not in that situation. Congratulations, you can stop reading here. If you are not sure whether you have an upside-down loan, then your first course of action should be to check it out. Compare the balance you owe to the current Kelly Blue Book balance. While you are at it, you might want to take note of the interest rate on the loan because that will be the topic of a later post.

If you are upside-down, you should take no comfort in the fact that you are not alone. The Auto Industry Forum quotes research that indicates that anywhere from 26% to 40% of consumers are upside-down on these loans. You are looking for financial independence and need to do better than the crowd. You should use it as an early warning sign that you need to shore up your finances.

So an upside-down value does make life more difficult – but not impossible. You just need to remember one of the cardinal rules – stopping digging!! The last thing you should do is trade the car/truck in and roll the shortfall into a new loan. There really is no easy way out of this but you can take some comfort in learning an important financial lesson on a relatively inexpensive purchase (read this to mean you can AVOID having the same thing happen to you on your home mortgage).

We are looking to fix the problem here so I won’t talk too much about how to prevent this situation. The easy rules are 1) don’t finance more than 90% of the value and 2) keep the loan shorter than your intended holding period. If you want to read more, I suggest you read the Bankrate article, 9 ways to avoid, correct upside down car loans. One final word. Some might advise you to buy gap insurance to protect you from an upside down situation. As a former insurance executive I will tell you that, in my opinion, this is just a gimmick to raise your payments and take advantage of your need to trade in cars quickly. Holding the car longer than your loan is all you need to do. If this is an issue, then you are not learning what it takes to become financially independent. I would avoid leases for the same reason.

If you are upside-down there are three things you can do to fix it.

  1. Keep and maintain the car/truck – The piper must be paid. If you are unhappy with this option, do it anyway. Just funnel your anger positively by reminding yourself that you won’t let it happen again. If you are still mad, look at item three below.
  2. Try to refinance – This option, it difficult but worth trying especially if you have a very high interest rate and a relatively new or expensive car. When shopping around for a better deal you need to be careful and avoid too many credit inquires (as it will go against your credit score). You also need to make sure that you understand the terms of the existing loan and the new loan to make sure that you are not making the situation worse. You especially want to make sure that you are not extending the length of the loan.
  3. Make extra payments – Use the monthly payment to remind yourself that you are digging out of a hole. Make extra payments whenever you can as these will reduce the outstanding principal and lower the amount going toward interest (more on that later)

Take heart and understand that the problem will be fixed in a relatively short period of time if you stop digging. Whatever you do, DON'T trade it in as you will be compounding the problem. And learn your lesson for your next vehicle purchase. Always plan on a loan that is shorter than the expected holding time of the vehicle!

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