Definition:
A negative equity car loan is a loan where the amount owed exceeds the value of the vehicle.
How does a negative equity car loan work?
When you owe more on your car than it is worth, your loan is considered negative equity. Here are some common scenarios where a car loan can become negative:
Depreciation
A new car is an asset that depreciates in value; it takes you where you need to go, but it suffers wear and tear that can’t be repaired in the process. In fact, a new car typically loses 20% of its value in the first year of ownership and 60% of its value over five years.
You could combine the rapid depreciation of the car with a high original loan amount relative to the car’s worth – which means you paid more than you should have – and thus find yourself in a negative equity car loan situation.
Excessive wear
Excessive wear can cause the car’s value to deteriorate faster. For example, if you buy a new SUV and do a lot of driving off-road, the car may degrade faster than normal. Its value may be much lower than you hoped when you decide to trade it for a newer model, leaving you with the remaining loan balance on the new car.
Accidents
If you’re in an accident and your car is classified as a total loss by your insurance company, the insurer may declare the car a total loss and pay you the “book value” or fair market value. Since you owe more on the car loan than its value, you will have to repay a loan for a vehicle that no longer exists.
Trading in early
Many people find themselves in negative equity when they trade in their cars too early. This happens when the trade-in occurs before the loan reaches a point where the trade-in value of the car is higher than the remaining loan balance. The remaining amount will need to be paid off or added to the next loan, putting you in a negative equity car loan situation from the start.
How to deal with a negative equity car loan
If you want to get rid of a car that you owe more on than it is worth, you have a few options:
Postpone the trade-in
Delay the trade-in until you have paid off enough of the loan to reach a favorable equity position (when you owe less than the car is worth). This will allow you to take out a new loan that corresponds to the actual price of the vehicle, reducing the cost of the loan and preventing another negative equity car loan situation.
Roll the balance from the old loan into the new loan
Your monthly payments, interest costs, and total costs will be higher on the new loan when factoring in the negative equity, compared to the paid-off loan. If the new loan does not cover the full balance of the old loan, you may be obligated to make monthly payments on two cars with different loans.
Find a dealer willing to cover the balance
Car dealers may offer you a deal to get your business, but if you accept it, make sure to get the dealer’s commitment in writing to exclude the negative equity from the new financing agreement. Otherwise, some dealers might cover the negative equity but later roll it into the new loan or deduct it from the down payment.
How to avoid a negative equity car loan
It’s easy to avoid being underwater in a car loan if you follow some general principles:
Large down payment
The best way to maintain a favorable equity position in a car loan is to make a large down payment of 20% on any car you purchase. This will keep the loan amount (and thus the monthly payments and total loan costs) low enough for you to pay off the loan more quickly. For a car valued at $30,000, plan to make an initial down payment of at least $6,000 to stay above water.
Choosing
Short Loan Term
The faster you pay off your car loan, the less likely you are to fall into an upside-down car loan situation. The longer the term, the greater the potential depreciation and equity difference. Generally, choose a repayment period as short as possible. A loan term of 36 months is preferable to a 60-month loan, which is preferable to an 84-month loan. Although higher monthly payments may seem burdensome, they are worth the financial peace of mind if you can afford them.
Buy Within Your Means
The best way to avoid an upside-down car loan is to set a budget for your car and stick to it while shopping around. A good rule of thumb is the 20/4/10 principle. Put down a 20% down payment, choose a loan term of four years, and make sure your total monthly car expenses (including the loan payment, insurance, and maintenance) do not exceed 10% of your gross monthly income. For example, if you earn $50,000 a year, allocate a $10,000 down payment and be prepared to get approved for a 48-month loan, which allows you a total monthly cost of $417.
Trying to Sell the Car for More Than Market Value
While the simplest way to avoid an upside-down car loan is to keep the loan balance low, you can also try to sell your car through a private sale to a buyer willing to pay more than the market value, preferably at a wholesale price. Contact your car loan lender before selling to get their approval.
Key Takeaways
An upside-down car loan is a loan where the balance exceeds the value of the car, resulting in negative equity. You will need to pay off the negative balance if you want to trade in a car that you still owe money on. It’s best to settle the negative balance before trading in the car, but you can also roll the balance into a new loan or find a dealer willing to pay it off. You can avoid falling into an upside-down car loan if you take a loan that you can afford and seek a loan with a shorter term.
Source: https://www.thebalancemoney.com/what-is-an-upside-down-car-loan-4585198
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