What is Negative Equity ?
When you get a car loan and agree to pay it off over, say, 5 years there can be times during that loan in which you owe more than the car is worth. It’s called being “upside down” or “under water.”
If you wanted to sell or trade your car during this time of negative equity, you would need extra money to pay off your loan because the value of your car doesn’t cover the full amount you owe.
This situation can happen for a number of reasons:
- You paid too much for the car initially, which means your loan can be “upside down” from the very beginning
- You agreed to a very long-term loan that doesn’t get paid off as fast as the car depreciates in value
- You have a very high interest loan, possibly due to bad credit, which creates payments that pay down your balance very slowly
- You made little or no down payment and the value of your car depreciated at a faster rate than the rate at which you pay off your loan
- You purchased a car make/model that loses its value faster than similar cars of other brands
- Your car becomes damaged or not well maintained, which decreases its value
- You drive an unusually large number of miles each year, which creates a “high-mileage” vehicle with high loss of value
Who is most likely to have a negative equity car loan?
People who are most likely to find themselves in a negative equity situation are inexperienced young people who have limited income and less-than-great credit.
Inexperience temps these buyers to purchase more car than they can afford, with insufficient down payment and a high interest rate. They also opt for a much-too-long loan term as a way to create affordable monthly payments.
The result is almost certainly to be an upside down loan situation.
What can you do if you have negative equity and want to sell or trade?
Sell or trade? The two situations are different if negative equity is involved.
If you sell your car, the money must be used to pay off your loan. If that amount is not sufficient to fully cover the loan, you must come up with the difference in cash. Your loan company will not allow you to continue paying on the loan.
If you trade your car, you may have some other options.
If the amount of your negative equity is relatively small — less than 10% of the value of the new car — a dealer may be able to “roll” the amount into the new loan. It increases the monthly payment amount on the new car, and likely puts you right back into another upside down situation — not a good habit to get into.
The ideal way to resolve negative equity is to simply have the cash to pay it off. When trading, this means adding the cash to your down payment for your new loan.
Leasing is another option that can work for some people with negative equity
Since leasing provides much lower monthly payments than buying with a typical loan, rolling negative equity from a loan into a new lease can soften the impact.
However, this strategy will only work if the amount of negative equity is not too great. Furthermore, only brand new cars are leased, which means you might have affordability issues.
For more details on leasing, see LeaseGuide.com.
Are there other problems with negative equity?
If your car is stolen or is totally destroyed in an accident, your insurance (or the insurance of the at-fault party) only pays current replacement value, not the amount you owe on your loan.
If you are upside down when this happens, your insurance settlement, minus your deductible, doesn’t fully pay off your loan — which means you must arrange for the difference on your own. This can often be a financially devastating situation if you have a great amount of negative equity.
When does negative equity not matter?
So it seems negative is only a problem if you will want to sell or trade before your loan is paid off — or if your car is stolen or totaled.
If you keep your car and complete your loan, it’s not a problem. In fact this is the easiest and least expensive way to get out of a negative equity situation.
How to avoid negative equity and its problems
- Make sure you don’t over-pay for your car
- Never take a loan that is more than the purchase value of your car
- Make as large a down payment as possible on your car loan
- Shop for the lowest interest rate loan at banks and credit unions
- Avoid very long length loans of 72 months or more (60 months max on used cars)
- Repair damages and keep your car in good condition