Upside Down in an Upside-down Market

Through the years, at Driving Today, we have warned about the phenomenon of being "upside-down" in a car loan. Very simply, if you owe more on your loan than their vehicle is worth, then you are upside down. You might not even know it, and if you hold your car and make your payments through the conclusion of the loan, it probably doesn’t make much difference to you. But the severe recession we find ourselves in means that being "upside down" has serious ramifications, and consumers might find themselves caught in a double whammy. Let's look at how this insidious phenomenon affects individual consumers.

Most consumers find themselves upside down for a simple reason: the pursuit of the lowest monthly payment possible. There was a time when the "standard" auto loan was just 24 months. Then, as cars grew more expensive and lenders grew more lenient, loan terms stretched to three years, and four years; now, some industry data suggests the average car loan term is more than five years.

At the same time, in the past few years leading up to the current downturn, down payments shrank from an average of 20 percent to less than 5 percent, and "factory cash" often subsidized even that small down payment figure. Because of the long payment cycles and small down payments, a vast majority of car owners have just a tiny amount of equity (real ownership) of their cars during the first couple of years of ownership. Instead, for most, the finance institution is the actual owner. All of which would be essentially transparent if car buyers held their vehicles until they were paid off. But they don't, especially in these hard times when a loss of job or a change in pay might cause many to re-assess the vehicle they own.

Consumers who are carrying a five-year loan may want to downsize or get out of their auto-related loan altogether, but if they are upside down, it is a tricky and expensive process. Just to make the old vehicle and old loan go away, consumers might find they must pay several thousands of dollars because their car is worth that much less than the money they owe on their loan. That’s the whammy, and the double whammy comes because the value of their car has likely dropped still more thanks to the current recession. In the past, consumers could “roll” the unpaid balance on their previous vehicle into a new loan for a new vehicle, but that was one symptom of a loosey-goosey credit policy that helped get us into the recession in the first place. These days, lenders are very reluctant to make those loans because they are now considered what they should have been considered then: very risky.

So what’s a consumer to do? Well, if possible, we suggest hanging on to the car and paying through the end of the loan. It might not be easy, but this will be the best bet to maintain good credit status. Another possibility is to look for a private-party buyer for your car rather than trying to trade it in. You could get more for your car this way, which will help with what is euphemistically called “negative equity,” which is, in actuality, debt. If that fails you can enter into a negotiation with your finance company. Odds are, they want your car even less than you do, so you might be able to work out new loan terms that you can live with.

Five years ago, in this space, one of my Driving Today colleagues wrote, “The auto industry, which now seems to be fueling the upside-down trend, would also be a casualty [of loose credit policies] because as finance companies rein in their loan practices in response to more and more defaults, fewer people will qualify to buy new cars.” Now that has come to pass. We hope you’re not being caught in the vice.