What Is Negative Equity and How Does It Affect Me?

I make my car payments every month just like I’m supposed to, so how did I end up owing more than my car is worth?

Negative equity is one of the biggest obstacles to refinancing a car. It is also one of the most common sources of confusion surrounding car loans.

For most women in this situation, the problem began at the loan’s inception. Here’s what you need to know about equity before you buy your vehicle.

What You Need to Know First
Negative equity is often referred to as being “upside down” or “underwater.” It refers to a situation where a loan on a car is larger than what the vehicle is actually worth.

Being upside down is most common at the beginning of one’s loan term, just after the purchase of the car. It is less common to have negative equity for a majority of your finance term. Being underwater on your loan, if it happens at all, should be very temporary.

A majority of these situations are a result of longer loan terms, a zero or small down payment, or a combination of both.

Compounding the Problem: Changing Values
Are you safe if your loan term is not overly long and you made a significant down payment when you purchased your vehicle?

You certainly reduced your chances of getting underwater with your car loan, but it is always important to remember that your car’s value, while a factor, is not set in stone.

You may have partly based your car purchase on how it would retain its value over time. However, unforeseen issues — like the Volkswagen public relations crisis, for example, or a dramatic change in gas prices — could unexpectedly reduce the value of vehicles that once retained their value. These changes over time can also directly impact your equity situation.

How to Stay Right Side Up
You can avoid negative equity by limiting your car purchases to those you can realistically afford. Consider making a significant down payment and choosing the shortest loan term you can afford.

While you can’t stop depreciation or anticipate issues like the Volkswagen scandal or gasoline markets, you can use a depreciation calculator to monitor the value of your vehicle over time.

Also, when purchasing the car, choose from more popular vehicles, selecting a marketable brand and color.

If You’re Really Worried, Get GAP Insurance
Negative equity only becomes a major concern in two cases. The first is if you need to refinance your vehicle. If you don’t plan to refinance, you don’t need to worry. However, there is another situation that you can’t plan for. Negative equity becomes a more serious problem is if the car is stolen, or is in an accident, or is damaged beyond repair in a natural disaster. You could end up owing a significant amount of money to your lender, as the insurance company will only pay the car’s value at the time of the incident. Guaranteed Asset Protection, known as GAP coverage, is designed to protect car owners from negative equity.

When You Are Upside Down

Don’t panic! Keep making your monthly payments and consider whether you can apply any additional money each month to the principal of your loan. Even tiny payments can make a big difference over time. Also, go get GAP coverage. When you find yourself right side up again, you can cancel it.

Jennifer Bonessi is a member of the DailyWorth Connect program. Read more about the program here.