If you’re interested in buying a car, you may have heard the term “underwater” used to describe a situation with a car loan, as in, you or someone else is underwater in their vehicle. Obviously, this doesn’t mean their car is literally flooded, so what exactly is underwater? We have the answer.
The phrase underwater is primarily used in the car industry to describe someone who owes more money on a vehicle than it’s actually worth. In other words, if your vehicle is worth $10,000, but you have $12,000 in remaining payments left on the loan, then you’re underwater in your vehicle by $2,000. You won’t become above water, or put another way, you won’t begin building equity until you’ve paid your loan to the point where the car’s value is more than you owe on it.
How Does It Happen?
How exactly does a car owner get underwater? There are a few ways, really. The most obvious and most common way is they finance a vehicle that depreciates faster than they pay off the loan. If you take out a 5-year loan on a $30,000 car that loses a third of its value in the first year, then you’ve probably only paid off around $6,000 of the car’s value at the end of year one. At that point, the car is worth $20,000, but you still owe $24,000 on it, meaning you’re underwater by $4,000.
Drivers who pay a high interest rate on their car loan will also find themselves underwater unless they bring a substantial down payment to the sale. High interest rates cause you to spend far more than the cost of a car over time, which means you can easily owe more than a car is worth as you drive it off the lot for the very first time.
Another way drivers get underwater is if they roll over negative equity, the dollar amount which you’re underwater, from a previous vehicle. Using the previous example, let’s say you now decide to buy a new car even though you’re $4,000 underwater. The dealer will roll your $4,000 balance into the price of the next car you buy, meaning you’ll be even more underwater as the car starts to lose value.
Unless you’re substantially underwater on a car loan, it isn’t necessarily a bad thing. In fact, it’s fairly common for the first year or two of a loan, especially if you’re buying a car with a long loan term. If you keep paying off your car, you’ll eventually start building equity as your payments catch up to the car’s value.