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How to get out of an upside down car loan

I spend a lot of time browsing the personal finance subreddit (/r/personalfinance). There is plenty of bad advice and no shortage of people who pop into threads merely to pat themselves on the back for being better than whoever submitted the post, but there is still a lot of really helpful information posted there and I think most people who post there walk away better off than they were before they posted.

One thing that has always cracked me up a little is how /r/personalfinance talks about cars. Everyone on there HATES cars. No matter how cheap your current car is, there is always a cheaper one out there (that has been only driven to/from church by an old lady) and you need to sell yours and buy it ASAP before your financial world comes crashing down on you. If Jeff Bezos posted on there that he was driving a paid-off 1996 Honda Civic, /r/personalfinance would flog him for not getting a 1992. But, I digress…

The backlash against cars isn’t entirely unwarranted – cars are necessary for many Americans, but they are expensive and people often pay more than they should for more car than they need, and do so under terms that are less than ideal. It kills me to see people posting on there who have a car that should have cost around $15,000, have been paying $400/month on it for 3 years, and still owe $20,000 on it. Yikes. That happens more often than I could have ever imaged before spending time on that subreddit, and it brings us to the topic at hand.

If I’m upside down in my car, how do I get out of it?

Upside down, underwater, negative equity – these all mean that you owe more on your car than it is worth. This happens if you overpay for a car, roll other stuff into the loan, or have less-then-optimal terms (ie, zero down or 6-8 years for the loan). Even if you don’t overpay for your car and put some money down, there is a chance you’re underwater at some point on your loan – by many accounts, 1/3 or more of car loans are currently underwater at any given time.

If you pay your loan off, this isn’t a big deal most of the time – at some point in your loan, you’ll have a car that is worth more than you owe again and everything is fine. But, people often find themselves in unfortunate financial situations (often times greatly contributed to by the car itself) and need to shed the monthly payment.

This is where /r/personalfinance becomes unhelpful and possibly even a little dangerous. If you post a budget breakdown on there and your budget includes a car payment, chances are, one or more people will tell you to sell the car and buy a cheaper one – depending on how bad it is, it may be the #1 overall suggestion. While this may be useful advice in some situations, it is often easier said than done and people driving by in the thread to tell you to do that never stop to find out enough information to know if that is the case or not. Unfortunately, the more dire the situation, the more likely the chances that the person has any good options in this area.

If you are in a happy situation where your car is worth more than you owe, it is indeed quite simple – sell the car, collect a check for whatever equity you had in the car, and buy yourself something more reasonable. What if you owe more than the car is worth? Here are the options:

1) Sell the car to CarMax

CarMax is a national car chain, known for no-haggle prices and for being willing to purchase your car without any sort of commitment to buy one of their cars. This solution is often very heavily suggested to people in this situation, and it is easy and fairly low-risk. However, CarMax is not a charity and will not give you more than your car is worth – indeed, of the 3 options, they’ll usually net you the least.

That said, it certainly doesn’t hurt to get an offer from CarMax – at the very least, it will give you some idea of how other options stack up.

2) Sell the car private party

This route gives you the best opportunity to make the most off your car, thus limiting the damage a little bit. It also means the most work – listing the car, talking to buyers, dealing with flaky people, letting people take your car out for a test drive, etc. If you are in a tough spot financially, this work is often worth it.

It should be noted that one reason a lot of people cite for not going this route is the complication that this will add for the closing step. While coming up with the funds to cover the shortfall might take some work, the actual process of closing out your loan and selling the car to another buyer with their own loan is fairly easy – banks handle this situation all the time, and it isn’t a reason to not go this route.

3) Trade the car into a dealer

Another fairly easy option, especially if you are downgrading your car as part of this process. You’ll have to roll any negative equity into a new loan. There are two problems with this:

First, you are kicking the can down the road, not resolving the problem, and now you’ll have even more negative equity in your new vehicle, perpetuating your problem. This is a valid concern, but is often overblown and misses the point anyway – the negative equity you have is money that is gone and any way you get rid of it is going to cost you. If you’d have to take out a personal loan to make up the difference anyway, this option isn’t any worse than that (and might be a little better rate, too).

The second, and bigger, problem is that you may not be able to roll that much into a new loan. Banks limit how much they’re willing to loan above the value of the car that secures the loan – often to around 120%. So, if you are $5,000 in the hole on a $25,000 car and downgrade to a $10,000 car, you likely wouldn’t be able to make up the full difference this way.

4) Keep paying on the car

Often times this isn’t a terrible option, even if the situation isn’t ideal and people think you should get rid of it. Negative equity is a problem that will go away at some point in the loan lifetime, and trying to get rid of a car that you are upside down turns this problem into an immediate one that often requires a large outlay of cash.

5) Allow the car to be repossessed

If the situation is dire enough, then this may be your last and only option. Voluntary repossession is far preferable to having the bank have to hire a repo firm to do it for them – it’ll just add more onto the amount you owe. Note that giving the car back doesn’t get rid of negative equity or solve all your problems – you’ll still owe money to the bank, plus interest.

No Easy Way Out

There often is no easy way out of a bad car loan that you are upside down on, especially when someone is at the point where they are publicly asking for help to fix a bad financial situation. Advice to “just get rid of the car” is unhelpful without understanding all of the numbers involved – often doing so could make the situation even worse.

The other side of this is understanding how difficult it can be to get out of bad car financing situations – it makes a lot of sense to spend a lot of time on the process of buying a car to make sure you don’t get into situations like this.

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New Credit Card bonus categories for Q1 2017

A new year is here, and with it, new bonus categories for cards with rotating bonuses (Chase and Discover).

Chase Freedom

5% cashback on up to $1,500 in gas and ground transportation.

Discover, Discover it

5% cashback on up to $1,500 in purchases at gas stations, ground transportation, and warehouse clubs.

New Categories for Q3 2016

Chase Freedom‘s new bonus categories are Restaurants and Warehouse Clubs, both paying 5%. This bonus pays up to $75 for the quarter. This category is notable because Costco now accepts Visa cards, and the cash back at Costco is better than the Costco Anywhere card.

Discover’s new categories are Home Improvement and Amazon.com, both at 5% up to $75.

Also, the new Costco Anywhere visa is active and you can apply for it. It pays 4% on gas, 3% on restaurants and travel, 2% at Costco, and 1% everywhere else.

Comparison of different debt repayment strategies

Scientific American recently asked, why don’t people manage debt better? It is a really good question, and the article does a good job of showing how people make seemingly-irrational decisions about how to pay down debt. The authors argue that the most optimal way to pay down debt is to use extra money to pay down the debt with the highest interest rate first – and they are correct in stating that it is the most mathematically optimal way to do it.

It isn’t the only, way, though and there are some good arguments that the mathematically optimal approach may not be optimal for other reasons. The “Snowball” approach, popularized by Dave Ramsey, is another approach that works well for a lot of people – it is less optimal from a mathematical perspective but more optimal from a psychological perspective in a lot of cases, and that is important.

We’ll compare 2 methods of paying debt down more quickly – paying the highest interest rate first, and the snowball method. This comparison assumes a few things – 1) You have more than one debt, 2) You have at least $1 beyond the minimum monthly payments to pay down your debts more quickly, 3) You aren’t accruing new debt.

Let’s assume you have 2 debts:

Name Amount Rate Minimum Payment
Car Loan $10,000 5% 100
Credit Card $24,000 15% 480

Now, let’s assume you only pay the minimums. How long will it take to pay them off and how much will you end up paying?

Name Time Interest Total Cost
Car Loan 10 years, 10 months $2,963 $12,963
Credit Card 6 years, 7 months $13,899 $37,899

You end up paying $16,862 in interest, or $50,862 total on an initial amount of $34,000.

Now, let’s assume you have an extra $250 per month to apply to your loans, and when you finish paying on one, you’ll apply the payment you were paying before to the remaining one.

1. Paying the highest interest rate first

In this method, you pay $730 per month on the credit card until it is paid down while paying only $100 on the car loan, then when the credit card is paid off, you apply the $730 per month to it for a total payment of $830 per month. Here is what that looks like:

Name Time Interest Total Cost
Car Loan 4 years, 4 months $1,710 $11,710
Credit Card 3 years, 7 months $7,103 $31,103

Your debt is paid off after 4 years and 4 months, instead of almost 11 years. You pay $8,813 in interest, or $42,813 total on an initial amount of $34,000. This is the most optimal way to pay the debt down, from the perspective of paying the least amount of interest.

2. Snowball (pay the one with the lowest outstanding amount first)

In this method, you pay $350 per month on the car loan until it is paid down while paying only $480 on the credit card, then when the car loan is paid off, you apply the $350 per month to it for a total payment of $830 per month. Here is what that looks like:

Name Time Interest Total Cost
Car Loan 2 years, 7 months $669 $10,669
Credit Card 4 years, 8 months $9,609 $33,609

Your debt is paid off after 4 years and 8 months, instead of almost 11 years. You pay $10,278 in interest, or $44,278 total on an initial amount of $34,000. You end up paying $1,465 more with the same set of parameters, except which debt you pay off first.

$1,465 is no small chunk of change. So, why would you consider this method? There are two reasonably good reasons:

a) The psychological effect. For a lot of people, making more progress on a smaller debt may motivate them to stick to their plan to pay off debt and increase the likelihood that they will be successful. If that is the difference between sticking to a debt repayment plan and not, then the $1,465 is a small price to pay.

b) There is another benefit in that in a shorter amount of time, you get some more free cash flow ($100 per month in this case) that can be used to absorb other unexpected expenses and help you avoid getting into more debt. In this case, we get more cash flow after just two and a half years, versus over 3 and a half years for the more optimal solution.

Conclusion

The method you use is largely up to you – do you value saving the most amount of money, or is the psychological effect of a quicker win more appealing? The important thing is you make a plan and stick to it, and that you are aware of the tradeoffs of each method.

Savings accounts with sub-accounts

Having a bank that makes it easy for you to maintain multiple savings accounts can come in really handy – it can make organizing your finances simpler, budgeting easier, and saving for specific goals a lot easier.

How does it work?

Banks that support multiple savings accounts make it easy to create sub-accounts and give them friendly names (like “Emergency Fund” or “Trip to Hawaii”), and also make it easy to do instant transfers between them (and your checking account). For example, my setup in Ally looks like this:

Screen Shot 2016-01-23 at 2.30.09 PM

As you can see – I have a checking account and three savings accounts (one for part of our emergency fund, one to keep money we set aside every month to pay for car insurance and registration, and one for big purchases). Every month, I transfer a set amount to the car savings account, then split whatever leftover money we have between big purchases and our emergency fund. This is really simple – it took about 10 minutes to set it all up on Ally, and I spend about 3 minutes per month managing it.

Why do it this way?

Setting your account up with multiple accounts makes it easy to keep money separated and know how much you have for various expenses/needs. It also makes it easy to keep your emergency fund separate and not accidentally (or purposely!) spend it on things that aren’t really emergencies.

Do all banks support it?

Not all do, and even fewer make it simple. We have a full list of them here, and the best ones seem to be Ally and Capital One 360. If you know of another bank that supports this, please leave us a note in the comments.

How many accounts should I have?

It is up to you. Some people like to have more granular savings goals – ie, saving for a trip or other specific thing. I prefer to just have a few – one for an emergency fund, one for all big purchases, and one for all expenses that are fairly large but only happen a few times a year (this makes our budget smoother).

Can’t I just track it all in a spreadsheet?

You certainly can, and it isn’t terribly hard to do so. Many people – including me – really like the convenience offered by having them separated in the account itself, though.