22 December 2020 Concept Car
Maybe you’ve only read articles warning against being upside down on your loan. Or maybe you are upside down on your loan and you’re now asking yourself what to do about that.
Here’s the good news:
There’s no reason to worry about being upside down on your loan! Although it’s certainly not ideal, there are plenty of strategies to deal with the issue or to avoid it altogether.
We’ll cover all of that and more in this expansive feature. As you’ll quickly see, far too many self-declared experts are making far too much out of this.
The moment you buy a car, the value of the car and the value of the loan are usually identical. Unless you make a down payment or have some debt you need roll over from a previous loan, you will borrow precisely the amount you need to purchase the vehicle.
So, for a £10,000 car, you’d need to borrow £10,000.
So far, so good. But what happens once you drive that car off the lot? It starts depreciating. Over the first year, your car will lose up to 30% of its value. So that, after twelve months, it will now only be worth £7,000. https://www.theaa.com/car-buying/depreciation
However, it’s more than unlikely that you’ll have paid back £3,000 of your loan. So you’re debt is now higher than the value of the car.
This scenario can still get worse in the second year. Although the depreciation curve is now flattening, it may still be higher than your interest rate. Which means that the divide between debt and worth keeps increasing.
This is what being upside down means: You now own a car which is worth less than the loan you took out for it.
Here’s the reason why so many experts warn against ending up in this situation:
Let’s say you went ahead and bought that £10,000 car, borrowed £10,000 and drove it for two years. Let’s also assume by now you paid off £3,000, so you have remaining debt of £7,000. If depreciation amounted to 45%, then your car is now worth £5,500.
Imagine this: You slam your car into a brickwall, Your insurance will cover the cost, but only to the current value of the vehicle. At the same time, you will still have to pay back your credit. Which puts you £1,500 into the red.
It also means that if, at any point during these first two years, you want to sell the car, you will not get enough for it to cover the cost of your debt.
It doesn’t take a lot to see why this can be a serious issue.
It is easy to deduct from what we just said how you can get upside down on your loan.
For one, depreciation is very high for a new car over the course of the first two years. This isn’t rational in some respects. The car is still as good as new, after all. Still, it seems like this unwritten rule of the car industry won’t go away anytime soon.
Depreciation, however, isn’t the only factor contributing to being upside down.
Obviously the fact that you need to borrow a very high sum also plays a role. If you were to make a downpayment of £3,000, for example, you couldn’t get upside down, because you’re already below the impact of depreciation.
Finally, the speed of repayment is a vital part of the equation. If you were to make higher monthly instalments, you could try to outpace depreciation.
The slower you pay your loan back, the higher the chances of getting upside down on it.
This is actually a far more sensible question than some are trying to make you believe.
As we’ve shown earlier on, being upside down on a loan can be a problem …
Now, for one thing, the first situation is not actually that relevant for the majority of drivers in the UK. Most of us take out a car loan with the dealer, rather than the bank. And since most of these loans are based on a PCP or HP model, we don’t own our cars anyway. Until they’re paid off in full, they still belong to the dealer. So you can not just sell the car, even if you desperately need the money.
The second situation is more problematic. But it’s not nearly as common as you might think. Looking at the official statistics, the number of serious accidents (as part of which a car might get totalled) on UK roads is very low, In fact, it’s so low it’s almost 0!
Still, just for the sake of it, let’s think about this some more.
If you’re still worried about being upside down, there are some things you can do. Let’s take a closer look at them.
Of course, we’re not always rational in questions of finance. This is why quite a few drivers still take out gap insurance when buying a car.
As we’ve described, the problem of being upside down is that there is a difference in value between the car and your outstanding debt. If things get ugly, this can cause serious financial problems.
A gap insurance can be of use here. If you do end up crashing your car, it will cover that gap and thus insure you won’t have to pay back any money on a car you can no longer use.
We’re not big fans of gap insurance.
A typical premium for gap insurance would amount to £300 for three years. That’s money you could have just as well used to make a better down payment, which would also have reduced the risks of being upside down. Also, you urgently need to look at the fine print to make sure what the insurance covers and what not.
If you’re in need of peace of mind, however, there are worse things than gap insurance.
Have you read?
Car insurance: What do I really need?
No, by this we don’t mean paying in cash, which will usually be impossible. But, as mentioned before, making a notable down payment really does help. And it’s not impossible, either: if you wait just a few months longer before signing the papers, you can save up to a decent amount. This will not only reduce the risk of getting upside down, but may also get you a better interest rate.
If you need to pay taxes and fees, we also recommend paying these upfront instead of making them part of the loan. Anything that reduces the loan is good. Anything that increases it means you’ll risk getting upside down earlier, for longer and with a bigger gap.
We’ve written about this many times on this blog. But we can’t emphasise it often enough: There is a lot you can do to make a loan easier for you.
You can take more time to pay back a loan if you can only pay back a little each month. Or you can try to pay it off faster and aim at higher monthly instalments.
You can prioritise low interest rates or you can focus on making sure you can actually pay the loan back.
If you want to reduce the risk of getting upside down, it helps to reduce the loan term, increase your monthly payments and bring the interest rate down. The less you pay in interest, the more you can pay off the actual loan – which will contribute to remaining on the right side of the loan.
If you keep your car for the full duration of the loan, then the only thing that can get you into trouble is getting into a serious accident.
This is the thing about being upside down: It’s really only a short phase and usually won’t even register. This is why so many experts are making far too much a big thing out of it.
In many articles on being upside down you will find the recommendation to buy a car that holds its value well.
The idea behind this suggestion is that if the car’s depreciation is rather low, you won’t get upside down quite as badly.
Obviously, this is a flawed logic. These cars are quite a lot more expensive, precisely because they’re in demand and hold their value well. As a result, your loan will be higher, too. But even if the strategy does work, you’ll have to pay back the loan for longer, which in itself increases the risk of a default.
It’s a bit like fighting fire with fire.
Instead, it’s a far better idea to always buy used and to opt for the cheapest model you can find. Sure, it will depreciate faster. But the loan will be lower, so the gap won’t be quite as big.
To us, this seems like a far smarter way to reduce the dangers of being upside down.
Finally, there’s one more thing you can do to reduce the risks of being upside down: Improving your credit rating.
Why would this matter? It’s simple, really: The better your credit score, the better your chances of a good deal – i.e. lower interest rates. And the lower the interest rate, the faster you can pay back the loan.
The great thing about this strategy is that it won’t just improve your loan in terms of being upside down. It also saves you money in the long run.
Which is a good way of looking at the upside down question in general: Instead of making a big deal out of it, use it as an opportunity to improve your finances overall.
If you approach things this way, we actually think you can come out of this with substantial gains.
Have you read?
How to improve your credit score
22 December 2020 Concept Car