What Does It Mean if a Loan is “Upside-down”?

It is said that new cars lose value as soon as you drive them off of the dealer’s lot, and for some reason it’s quite true. A new Dodge Grand Caravan can easily run you $25,000-30,000. The price dips to $20,000 just 20,000 miles later.

One might argue that this is a good reason to never buy a new car. There are many arguments for and against that statement. One that banks don’t miss, however, is that unless you put a substantial down payment when buying your car, the vehicle that the bank has a lien on cannot be sold for the full amount of the loan you took out.

The standard way of dealing with this on cars is to purchase “gap insurance”, which basically says that the insurance company will cover the difference between your loan and the value of the insured car. It probably won’t be a condition of the loan, and if it is you might want to look elsewhere for financing in case the insurance they offer is overcharged. Gap coverage is an excellent idea, however. It will avoid the unpleasant situation of paying off a loan for a car that you no longer drive.

We run into this with houses, too. If the house of a value falls below the mortgage, it’s said to be “upside-down”. This does not automatically mean that the borrowers were irresponsible. If you put down the standard 20% down payment, and even paid off another 10%, leaving a 70% mortgage, a market drop of 1/3 will put your house under. It happened all over the country.

Much of the “help to homeowners” that the government has been giving people since the housing bubble collapse is allowing short-sales. If the government agrees to an offer on your house, you can sell, give all of the money to the bank, and the government will make up the rest. The case above suggests how tragic this can be. The homeowner’s would have lost all of their down payment and paid equity. But if you have to move, or you can’t make the payments, it’s better than foreclosing.

Homeowners insurance, particularly for fire, offers a type of protection for loans as well. How much protection you buy on your house is often up to you. What you can buy, however, is whatever amount is necessary to “rebuild” the house. A newly built house is almost certainly worth more than the one that was destroyed. No one has yet splashed water out of the tub or put a fist through the wall.

Now the money they give you will not pay off your mortgage, because the land your house sits on was not destroyed. In theory you would have to rebuild the house to get yourself above water again. In practice, however, many developers are thrilled to find a vacant piece of land in a developed neighborhood. It’s a rare chance to give buyers exactly what they want where they want it. It might be just as well to sell the land at a premium, by another house, and bank the difference.

Post a Comment

Your email is kept private. Required fields are marked *