The Risks of Upside Down Car Loans

Upside down car loans happen when the value of a borrower’s vehicle is less than the loan.  This occurs when interest rates rise and fall rapidly and a borrower finances the purchase of a vehicle with a loan that is too high relative to the prevailing interest rate.

When a car loan goes upside down, it creates some issues for the borrower.  The resulting higher interest rate that is being paid into an asset that is rapidly diminishing in value means that there is a potential the loan will go into default. A borrower with an upside down loan cannot sell the vehicle or take other actions to reduce their liability associated with the loan, because even if the vehicle is sold, the amount received in the sale would be less than the value of the loan.

Higher Interest Rates

The higher interest rate resulted from a dramatic change in interest rates from the time the loan was made until the time the contract was signed. Over time as the value of the vehicle depreciates, it becomes too expensive to keep and a potential liability to sell. This liability is represented by the gap between the car’s value and what can be obtained through a sale.

No Value

The gap between the car’s value and sale price means that vehicle is relatively worthless. Its only value stems from any intrinsic value to the owner as they attempt to reconcile the fact that they are paying more for the car than what is worth in the open market.

Potential Loan Default

A car owner with an upside down car loan finds themselves with limited options relative to the loan. If they are unable to renegotiate the loan or change the terms to make them more favorable, it is possible that the borrower can simply default on the loan. A loan default means that the borrower will take a hit to their credit score, which will make it more difficult to borrow in the future.

These and other risks associated with upside down loans can be reduced somewhat when a car purchase is made. The terms of the loan should be reviewed and the interest rate should be reasonable, relative to both current and projected rates. Borrowers who receive a loan at a high interest rate and who do not put any money down on the vehicle are subject to a greater risk of becoming upside down on the loan than do borrowers who reduce their loan-to-value ratio.

 

 


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