Many people are familiar with the term ‘negative equity’ in mortgage cases.
But have you heard of negative equity in the case of car loans?
In very simple terms, you are in negative equity if the amount of money you owe to your lender is more than the current value of your vehicle.
It is not uncommon to be in negative equity in the initial stages of your loan term, but being in negative equity towards the end of your loan term can make the process of purchasing a new car difficult.
Negative equity also affects a new car loan.
How You Get Negative Equity
Let us say you purchased a new car on a loan agreement which is worth $40,000 and you have made two monthly payments of $1000.
It is a well known fact that the moment you purchase a car and drive it off the lot, it loses about 9-11% of its value. If after two months, your car has depreciated in value by $4500, your car will be worth only $35,500. However you have made only a payment of $2000 in two months so you will have $2500 of negative equity.
An important point to note is that your new car will lose most of its value in the first few months of purchase. After that, the depreciation rate slows down and you will reach closer to positive equity.
Because of this, having negative equity in the beginning shouldn’t be very concerning. As you make more repayments, you will inch closer towards positive equity and eventually reach it.
However in some cases you can still be in negative equity towards the end of your loan contract. In this situation, it is way harder to reach positive equity.
If you want to sell your old car and purchase a new one, negative equity can affect your new car loan.
How Negative Equity Affects A New Loan
- The first and most obvious effect of negative equity is that you will owe your lender more money than what your car is worth.
If you owe $17,000 on your car loan but the current value of your car is $14,000, you will have a negative equity of $3000. If you don’t have the cash to pay the difference but you need a new car, your dealer might let you roll your negative equity into a new car loan.
This means that you will be borrowing more than what your new car is worth. This will also mean higher interest rates on your new loan.
- If you have negative equity, your loan term will be longer than normal.
The standard loan term is about 36 months and you should be able to break even by the end of this term. If you don’t, your loan term will have to be extended and your car will have lost most of its value by the time you finnish paying off your loan.
If you decide to get a new car loan, you might enter into another cycle of negative equity and keep making repayments for years.
- When your loan term gets extended, you will be paying more interest over time which will cause you to lose even more money.
If the amount of negative equity you have is small, this might not be a huge problem. But if it is big, you will be losing a lot of money over time.
The only way you can make sure your new car loan term is not going to be very long is by making a big down payment. But this is possible only if you have the cash ready with you.
How To Deal With Negative Equity
Many people wonder how to deal with negative equity on a car.
If you want to purchase a new car with negative equity on your old car loan, there are a few methods you can try.
- Roll the negative equity into your new car loan if the amount isn’t high or you are able to make a big down payment on the new loan.
- Sell your car privately.
- Sell your car and pay the difference.
- Try negotiating terms of the loan contract with your lender.
- Delay trading your car to see whether you can get rid of your negative equity.
It is not impossible to purchase a new car when you are in negative equity, but it will be more difficult than usual. Before you secure a new loan, make sure you talk about the risks with your dealer.