Personal Finance Advice

What does it mean to be “upside down” with a loan? You may have heard this term used lately with regards to both auto and home loans, and if you don’t understand what it means then there is at least a good chance that you know it means something bad. When people lament about being upside down with a loan, they never sound happy about it.

When you are upside down in a loan, this means that you owe more than the item you have the loan for is worth. This used to be much more common with auto loans than with mortgage loans, but with the economy in turmoil it has become much more common with mortgages than it used to be.

How does this happen? With auto loans, the rapid depreciation of most cars is usually enough to make force a borrower into upside down status until enough payments are made on the loan to pay down the principal balance substantially. On the other hand, with home loans, it can be a little more complicated. Homes are supposed to increase in value, also known as “appreciation.” The problem is that sometimes home values appreciate too much, which results in a real estate bubble where the home values start to plummet in some areas. People who bought the homes when they were valued at record highs -or people who took out equity loans on their homes when the values were high- can quickly find themselves upside down in their home loans as the value of the home goes down.

How can you avoid someday winding up in a position where you are upside down in your payments? Making a substantial down payment on whatever it is you’re buying (whether it’s a car or a home) may help you to avoid a bad situation in the future. Making additional principal payments can also help. Nothing is more important than not making a purchase that has the real potential to become upside down. Know the depreciation rate of a car before you buy it, and if possible, by a used car instead of a new car. Used cars have already taken the huge initial depreciation hit when they were first purchased by the original owner, so this can be a great way to try to keep from owing more than the car is worth.

With a home, things become a little trickier. If possible, buy a home with as much money down as possible, and purchase the home in an area with a long history of solid home value appreciation. This can be nearly impossible if you are buying a new home in a new development, but do your research nonetheless. Most importantly, try to avoid borrowing backed by the equity in your home. This can be a great way to borrow money because of the low interest rates and potential tax deductions, but you have to decide if it is worth it to place yourself in a position where you might find yourself upside down.