Now Might Be a Great Time to Get Out of Your High Interest Loan

Interest rates hit record lows this year as the Fed braced itself for economic uncertainty due to the coronavirus pandemic. Edmunds data has shown that over the past month, interest rates on car loans have fallen nearly 3 percentage points and are creating a favorable scenario for car shoppers who are stuck in a loan with a high interest rate and owe more than the vehicle is worth. Rising residual values for used cars also mean you might get more for your car than you think.

One year ago, the average interest rate for loans involving a trade-in with a carried-over balance was 7.3%. In April 2020, the average was down to 4.7%. That's a huge decrease, thanks in large part to a number of 0% financing offers, and it means that buyers picking up cars right now will save thousands of dollars over the life of their loan compared to buyers who bought just last year. On a $35,000 loan, the average change in finance rates adds up to more than $3,000 in savings, but with a 0% loan the difference is upwards of $6,000.

If your credit is good or recently repaired, you might qualify for one of the numerous zero-interest loans available right now. That could add up to thousands more in savings — potentially more than enough to offset what you owe on your current vehicle and get you out of continued payments at your higher interest rate.

How Much Can You Save?

With 0% loans available, buyers can save thousands of dollars and get on a path to building equity in their new cars faster. Let's look at some examples of moving from a 72-month loan at a 6% APR to an 84-month, 0% loan, whether you're financing the same amount, more or less.

As you can see, even a slightly larger loan still results in lower payments, but benefits extend beyond just bringing down your monthly payments. With a 0% loan, every payment you make goes entirely to principal rather than paying down interest. That means your money goes directly to building equity, and you can expect to have positive equity in your vehicle roughly halfway through the loan. Even though the loan term is longer, you'll be in a better position to trade your vehicle in before the full term of the loan if you want to.

It's important to remember that the amount you finance includes anything you might owe on your current vehicle. If you owe less on your car than it's worth, you're in a strong position. But even if you owe more than your car is worth, a 0% loan is worth considering provided you aren't too "upside down."

The Negative Equity Problem

Owing more on a car loan than its value is called being upside down or "negative equity" in the car business. This tends to happen when a person doesn't make a sizable down payment or trades in a vehicle before the loan has been paid off.

We've been outspoken about the problems with both high-interest and long-term loans. Loans with 72- and 84-month terms are becoming more common, and while they offer lower monthly payments, they have a number of drawbacks. For starters, many buyers don't want to keep a car for seven years. They get bored, or their situation changes and they want an upgrade. (Or they get tired of paying maintenance costs after the warranty runs out.) But the bigger deal is that with a long loan term, it takes longer to gain equity in your car.

A new car loses just over 20% of its value its first year, and the trouble is most people only make a down payment of about 11%. They still owe the remaining balance plus interest, and it will take a while to pay down the loan enough to build some equity. And the longer your loan term, the longer that usually takes. Until you reach that break-even point, you have negative equity.

Many buyers have been choosing to trade in their old cars anyway, rolling what they still owe into their payments on a new vehicle. Normally, we'd strongly advise against trading in a car that you owe money on, but the current situation is a bit unique. If you've been able to build up your credit and you can secure low- or no-interest financing on a new loan, rolling over your negative equity may allow you to reduce (or keep equivalent) your monthly payments. It's an opportunity to get out of a high-interest loan on an upside-down car without absorbing a large financial hit up front.

If you're stuck in a high-interest loan, even if you have negative equity in your current vehicle, you might be able to take advantage of the generous financing car companies are offering due to the coronavirus pandemic to save yourself some money. Here are a few tips to consider.

Step 1: Determine What You Owe

First, you'll need to know how much you owe on your current vehicle, which should be easy to find out. Just check your monthly statement or log in to your finance company's website, which should indicate the remaining amount.

Next, figure out how much your car is worth right now. We recommend using our online appraisal tool, but you can do the legwork yourself and contact dealers to get trade-in quotes. There are dealerships willing to offer a quote remotely, so you can still practice social distancing. You'll likely have to write up a thorough account of the vehicle's condition, and take plenty of photos to send to the dealership. Check out our Coronavirus FAQs for more information and strategies to stay safe.

Increasing demand for used cars means you may be able to get more money for your trade-in than you would have just a few months ago. In July, the average value for vehicle trade-ins increased 16.4% over June. You could have more equity in your vehicle than you think, and if you're in a position to, now is a good time to take advantage of strong demand for used vehicles.

Then all you have to do is subtract what you still owe from the trade-in value of your vehicle. If you have negative equity, this amount is what you'll be rolling into the new loan. Note that, on average, people who financed at a dealership in April rolled about $5,800 of negative equity into a new loan, according to Edmunds data. If you owe much more than this, the strategy we're suggesting may not work since the new loan might end up being more expensive than the one you're trying to get out of.

Step 2: Compare Loan Terms

The next step is to find out what kind of interest rate you can get. It's good to start by deciding what vehicle you'd like to trade into, whether that's a newer version of your current car or something else entirely. If you're willing to downsize or downgrade your choice, you're more likely to come out ahead since you won't have to finance as much to cover the price of your new vehicle.

For example, you might consider moving from a compact luxury SUV to a mainstream SUV, or from a full-size truck or SUV to a midsize. This kind of move wouldn't necessarily be a step back since today's affordable vehicles offer a lot of features once reserved for luxury vehicles, and midsize trucks and SUVs leverage modern technology and packaging to provide lots of functionality and utility. It's worth doing your research because you might give up much less than you think and save a significant amount of money.

Once you've picked the vehicle that's right for you, you have a couple of choices. You can use a loan calculator to check your current finance charges and compare the loan details to a vehicle with a 0% APR loan. This calculation will give you an idea of your new payments, but it won't help you find out if you qualify for promotional interest rates.

To get the most accurate idea of what you can afford, you'll need to contact a dealer and find out what it can offer you. Only the dealership can tell you if you qualify for a promotional interest rate. You'll need the dealer to provide you with your final out-the-door cost and your interest rate. Make sure to get an appraisal on your trade-in, so you can calculate the exact monthly payment.

And that's it! Once you have the numbers in hand, you'll be able to see how much your payments have changed and whether you can spend less overall or just save some money on interest payments.