How To Trade In a Car That Is Not Paid Off
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How To Trade In a Car That Is Not Paid Off

By Autolist Editorial | April 6, 2021

What do you do if you want to get a new car, but you have not paid off your current vehicle? You could sell your old set of wheels, clear the balance on your loan, and make a down payment on a new model with whatever cash is left over.

However, to get a good price for your old car, you have to put up an ad, field phone calls, schedule appointments, invite strangers to your garage, and haggle over the price.

If that sounds like too much work, you may consider trading in your old vehicle. In some states, there may also be a sales tax advantage to trading in your car, rather than selling outright. Be sure to check your state's sales tax laws for trade-ins.

Many car dealerships accept trade-ins with vehicles that have not been paid off. Most of these dealerships even promise to pay off the balance on your auto loan.

However, unless your local dealership is a charity, it will not make your loan disappear; they will pay off what you owe your lender and find a way to factor the expense incurred into the price of the vehicle you purchase.

Before you begin negotiations, you should understand how the trade-in process works to avoid unpleasant surprises down the road.

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How Trade-ins Work

When you approach a car dealership and ask to trade in your car, a representative will test drive it, appraise its value, and make you an offer. You may want to use estimates from online pricing guides, like Kelley Blue Book, to negotiate the value of your trade-in and the price of the car you want.

It is unlikely you will get the full value of your current car, compared to the price it would be worth in a private sale. When you reach an agreement, the dealership will calculate the difference you have to settle to get the new car and sign over the title of your old car to the dealership.

To calculate the net cost of your new vehicle, the dealer will subtract the value of your old car from the price of the vehicle you want. If your 2016 Chevy Spark is worth $6,000 and you negotiated the price of the 2021 model you are interested in down to $14,000, you will pay or make arrangements to finance the balance of $8,000.

If you owe money on the car you are trading in, the dealership pays off the loan, assumes ownership of your trade-in, and applies the difference between the value of your car and the balance of the loan on your trade-in to the price of the vehicle you are going to purchase.

If the payoff amount is $2,000 on your 2016 Chevy Spark (which you agreed is worth $6,000), the dealer will pay off the loan and subtract the extra $4,000 ($6,000-$2,000) from the price of the car you purchase.

In this case the surplus value of the car, beyond what is owed on the current loan, is called positive equity. Since the price tag on the 2021 model is $14,000, you will pay or finance the balance of $10,000.

Trading in With Negative Equity

If you owe more on your old car than it is worth, your set of wheels has negative equity. In dealership parlance, it is upside down or underwater. In this case, the dealer will add the difference between the loan balance and the value of your trade-in to the price of your new car.

Suppose, for example, that the remaining balance is $8,000 on your 2016 Chevy Spark. The dealer will take the car as a trade-in and add $2,000 ($8,000 loan balance minus $6,000 trade-in value) to the price of the new car you want.

Take note that rolling over your negative equity to your new car loan increases your monthly payments because you are now paying interest on the principal and the rollover amount.

If you were to take out a 60-month, 9 percent interest car loan on the $14,000 Chevy Spark, you would make monthly payments of $291, and the total interest you pay would be $3,460. If the dealer applies the negative equity from your old loan to the car, you would be borrowing $16,000 instead.

Given the same term, and at the same interest rate, your monthly car payments would be $332, and the total interest you pay would be $3,920.

This will also make you upside down on your new car, before adding even one mile to the odometer. People sometimes get stuck in the cycle of rolling over old debt into new car loans, and never get out from under the weight of previous loans.

This is even more problematic as car loan terms stretch out to longer and longer durations. The dealer will likely also try to sell you Guaranteed Asset Protection (GAP) insurance if you are getting a loan for more than the value of the car.

This insurance covers the difference in the car's value and the loan amount. If there is a significant difference, it may be worth considering. Be cautious purchasing GAP coverage from the dealer as your auto insurance provider likely sells this coverage at a much lower cost.

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Beware of Trade-in Scams

By law, the amount of negative equity a dealership rolls over into a new car loan should be reflected in loan disclosures as a refinancing of the old debt. Dishonest dealers who lure customers into their lots with the promise of making their auto loans disappear will use one of two strategies to bypass disclosure laws and recoup the money they lose when they settle the consumer's (your) old loan.

In the first instance, the dealership will offer you more for your old car than it is worth and inflate the price of the vehicle you are buying. If your 2016 Chevy Spark is worth $6,000 and you have $2,000 in negative equity, a dealer may offer you $8,000 for your old car and sell you the 2021 model at $19,000.

You may think you are scoring a great deal because the dealer is covering your negative equity and paying you $2,000 more for your trade-in than it is worth.

However, the dealer is making an extra $1,000 in profit because the best price you could get on the new Chevy Spark is $14,000. The dealer knows that you will be too ecstatic about making a killing on your old car to question the price of the vehicle you are buying.

In the second instance, a dealer will offer you financing terms with a high-interest rate as a precondition for accepting your trade. The dealership recovers the cost of covering your negative equity from the extra interest it gains.

In this case, the dealership violates the Truth in Lending Act (TILA) because it deprives you, the customer, of the opportunity to refinance the negative equity through other means.

Know Before You Go

Before you begin finance discussions with the dealership, it is a good idea to do a little research. Know the approximate value of your trade-in vehicle, and research the cost of the model you are interested in buying.

Check your credit score, and reach out to your bank or credit union about interest rates and loan terms for the amount you plan to finance. Though this will not give you exact numbers, you will be able to tell if anything is way out of whack.

Any numbers that are drastically off could be from the dealership hiding the rollover of your loan balance. If you have bad credit, it may be best to hold on to your old car, rather than face the high interest rates that some "buy here pay here" dealerships offer.

If possible, negotiate with multiple dealerships to get the best deal. Get anything you can in writing, and compare the offers of as many dealers as possible. Make sure to look at the total cost of the loan, interest rate, sales price of the new car, and what they offer for your old vehicle. Dealers will try to get you to pay attention to just the monthly payment, but that does not reflect the cost of the transaction.

Be sure to know the terms of your original loan. In 36 states, it is legal for lending institutions to penalize you for paying off your loan early.

These prepayment penalties help lenders make sure they reap the full amount of interest from the life of the loan, even if the car is paid off months or years in advance. Prepayment penalties may add a significant amount to the cost of closing out your old loan.

Is It Ever a Good Idea to Trade-In When You Have Negative Equity?

If you have the money, it is a good idea to pay off the difference between what you owe your lender and the value of your old car before you finance a new vehicle. This way, you do not have to pay interest on the negative equity that would be rolled over into the new loan.

If you do not have the cash, the next best option would be to wait on getting that new set of wheels until you pay off your auto loan, or at least until you have enough to cover the negative equity.

Granted, there are a few circumstances when trading in a financed vehicle may be a good idea. If your old car is a gas guzzler or costs more in repairs and maintenance than you anticipated, you could save money by trading it in for a cheaper model or for a vehicle that costs less to run.

It may also be a good idea to trade-in if the dealership offers extra incentives on the car you are eyeing. Toward the end of the year, dealerships often offer substantial discounts and better deals on car loans in order to meet sales quotas and make room for newer models.

How to Avoid Negative Equity

New cars face severe depreciation in the first few years following their purchase resulting in negative equity, or being upside down, as soon as a new car drives off the lot.

There are a couple of things to avoid to help limit negative equity.

During the car-buying process, you will often be passed off from a salesperson to a finance person. The finance person's job is to get you to add as many warranties or other packages as possible. You will have to decide for yourself whether the peace-of-mind of a warranty is worth starting out underwater before even even being handed the keys.

Other common packages include service and maintenance packages, tire and wheel protection, or paint protection packages. These expensive packages are added to the loan amount, which means if the financed car is worth $14,000, and you put $2,000 down, but add a $3,000 warranty, you now have a loan for more than the purchase price of the car.

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Bottom Line

When trading in a car, many car dealerships promise to pay off your current vehicle, but they only mean it if your old vehicle is worth more than you owe on your auto loan.

If you are upside down on your car loan and the promise to clear off your debt sounds too good to be true, it probably is. One way or another, the dealership will add the difference, between your car loan and the value of your old vehicle, to the price of your next car.

Keep in mind that if you can sell your used car yourself, you can keep more of the equity that disappears when you take a wholesale offer from an auto dealership.

The process of trading in your car for a new one can be intimidating, and a loan balance only makes it more complicated.

By using the simple guidance outlined in this article, you may be able to avoid major mistakes.

Be sure to do your research, do not be pressured into making a decision before you are ready, and be wary of any information that does not line up with your researched expectations.