What to do when you’re upside-down?

Here’s the scenario: you have a vehicle that you want to sell or trade-in for a different vehicle but you owe more than its worth (aka “upside down”). What do you do? For this scenario we will assume you have no extra cash to payoff the vehicle and there will be no additional cash towards a down payment beyond the licensing fees. Typically you will be more “upside down” the newer the loan is on the vehicle. If you purchased the vehicle on a 5-year term and you’re only 6-months into the loan, you will probably be much more upside down than if you waited until 2-years into the loan. So how do you determine when it’s better to take the hit by applying the difference between what you owe and what the vehicle is worth?

In the short run you rarely win by taking the hit. This is due to the fact that most people are trading up verses down. So people buy a more expensive car and transfer the amount owing onto a new car that will also go down in value. In the meantime the payments go up and loan terms get extended. Its a cycle that continues for years without end. So if the car in question is the only debt you have and you put all your extra money towards paying it off early, you should be out of debt and in a better position to get a new car (if you still want it) within a few years if not sooner.

In the long run you almost always win by taking the hit as long you follow the method I lay out. To illustrate this point here is a real life situation that one family faced. They owned two vehicles, owing $12,000 on a Dodge Caravan and $22,000 on a BMW. This family had a combined debt around $130,000 including these two vehicles. In an effort to reduce the overhead of the total debt I advised this family to sell both vehicles and downsize to vehicles that cost at least half as much. The problems came when they found that they were upside down on the van by $2,000 and the BMW by $6,000! Guys at one dealership wouldn’t even let them trade in BMW because it “wouldn’t be a smart move” by this family. That may have been true if they were only looking at the short-term impact, but if you look at the big picture it will blow away your thinking by how positive the impact would be even taking the dramatic hit, and here’s why. By trading the $22,000 BMW for a $7,000 car plus the $6,000 negative equity, they would end up with a $13,000 balance, and with $9,000 less overall debt. That debt reduction saves them 25 months worth of debt payments and almost $15,000 in total debt! Count’em 25…1,2,3,4…25! That means they are out of debt two years sooner and save $15,000 in the process. So you take a $6,000 hit and save 25 months and $15,000. Sounds like a smart plan to me. They would save even more by following that method with the van as well.

Auto dealers don’t see it this way because they are looking at the short-term impact and a lifestyle that says it’s normal to have a car payment your whole life. It’s part of their job to sell cars, so you shouldn’t expect them to give the financially prudent advice of not buying “brand new” cars that depreciate 30-40% the moment you drive them off the lot, and they definitely won’t tell you to buy only what you can afford. It will be buy only what you can “finance”. So next time you’re faced with the this decision I hope you consider the bigger picture in your equation.