Does It Matter If Your Car Loan Is Underwater?

You hear about underwater mortgages in every other finance article in the major publications. Does it matter if your car loan is underwater?

I get excited when writing about finances online, because when you do people will invariably talk to you about finance. If there is one thing I love more than writing about finances, it’s helping actual people with their finances. That’s why I wasn’t surprised to get a finance-related call from an old friend of mine. As most of finance conversations go, my friend tossed several interesting financial concepts at me.

Friend: “So, I’m thinking about getting a new car. My thought is this: I’m underwater on my car loan and I think this new car is going to hold value better.”

Me: “Why do you feel that this is such a bad thing? Being underwater on a car loan?”

Friend: “Well first of all, what happens if I total the car? Or worse, what if the car completely breaks down and I need a new one? Then I’ll still owe on my old car while also needing to buy a new one. I’m just thinking that buying a new car that holds its value is going to be a much better financial decision than holding onto a car when I’m underwater on my payment.”

This is not a line of financial reasoning that I see very often, but I’m not overly surprised. that my friend used this rationality After all, a large portion of homeowners are trying to walk away from their underwater mortgages. Does it make sense to extend that financial decision to other types of loans, like cars?

car under water

Understanding the Problem of Underwater Loans

We often take out loans to buy assets. An asset is financial-ese for some benefit that we hope to extract use from in the future. For example:

  • We take out student loans to get degrees that with earn us higher wages,
  • We take out car loans to be able to drive a car around for the next few years,
  • And we take out mortgages to own and use our dwelling place.

So, one basic assumption in taking out this loan is the extent of the future benefit. When we are wrong about that value, we end up in an underwater loan. Put simply: we owe more on the loan that the asset is currently worth.

This can be problematic for several reasons, especially with mortgages. What happens if the asset is uninsured and gets destroyed by some unfortunate event? Then we need to pay off the loan even though the asset has no use. The reason mortgages are particularly troublesome is that housing is not optional. If you were to lose your house and still owe a mortgage, how would you expect to be able to afford the new house or rent?
Being underwater on a loan also makes it difficult to sell the asset and move on. Underwater mortgages can prevent people from moving and taking new jobs. This also happens with cars. Banks can prevent the sale of a car in favor of a new one. In fact, given the depreciation on cars, underwater loans occur all the time.

Getting stuck with the asset you bought is danger worth considering, and it’s important to note that it is a concern that can occur with any loan you enter.

Does It Matter If Your Car Loan Is Underwater?

I hope that I’ve already convinced you that becoming underwater on a loan is a worthy consideration.

Car insurance provides good protection against losses from damage or accident and warranties protect against breakdowns. If you take out a car loan, you should be mindful that when the car warranty runs out, or you might have a big financial mess on your hands. That’s why you should match insurance and warranties to your loan terms in order to protect yourself from huge losses.

While you want to consider how a new car holds value before buying, you can see that an underwater car loan is not problematic like a mortgage. Insurance and warranties protect against being stuck with two car loans for one car. Unlike houses, cars are mobile, so they don’t prohibit you from moving around. In fact, cars are usually helpful for that type of thing.

The heart of the matter for my friend was that he wanted to buy a new car and was looking for an excuse to justify purchasing. Of course, having a potential underwater loan needs to be considered and planned, but it’s more of an obstacle than a deal breaker. Make sure you have proper protection on the vehicle while paying off your loan and up-side down loans aren’t really worth worrying about.

2 Responses to Does It Matter If Your Car Loan Is Underwater?

  1. As you allude to in the last paragraph, it doesn’t matter as much if you have GAP insurance.

    I leased a brand new card and paid an extra $12 a month for GAP insurance. If I had totaled the car in the first year, it would have saved me thousands of dollars. Luckily nothing happened, but it was nice to have peace of mind.

  2. I think being underwater on a car loan is risky, but it isn’t something that is going to burn down your financial house. Obviously the best thing to do is to pay cash for a car, the next best thing is to have a big down payment to give you some equity, and the least desirable thing is to be underwater.