Loans are paid off over time. Generally, each monthly payment goes partly towards interest costs and partly towards the loan balance. Eventually you pay off the loan balance. This is called amortization.
With an amortizing loan, you want the loan balance to get to zero before the item’s value does.
How Loans Get Upside Down
You get an upside down loan when the item loses value faster than the loan balance decreases. For example, a brand new car might cost $25,000. A few years later it might only be worth $15,000. If you owe more than $15,000 on the loan, you have an upside down loan. You’ll have to write a check to sell the thing, or keep paying for it after it’s worthless.
To avoid an upside down loan, you need to pay off the loan (or have it amortize) faster than the item loses value. For auto loans, you generally want loans that last less than 5 years. Longer terms can help keep monthly payments low, but you risk having an upside down loan.
Home Loans Upside Down?
Upside down loans on houses are more complicated because you might expect houses to increase in value over long periods of time. However, the subprime debacle starting in 2007 showed that falling home prices can create upside down loans. Certain risky mortgages can also do this.
Managing Upside Down Loans
If you find yourself with an upside down loan you need to be careful. You should decide if you need to get out from under it (at a cost) or if you’re going to let it ride. You should make extra payments if possible. For auto loans, you should investigate gap insurance to manage your risk.