You want to get a new car, but you haven’t paid off the one you have. 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 be considering trading in your old vehicle.
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; it will pay off what you owe your lender and find a way to factor the expense it 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.
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 such as Kelley Blue Book to negotiate the value of your trade-in and the price of the car you want. When you reach an agreement, you 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 2012 Ford Focus is worth $6,000 and you negotiated the price of the 2017 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 what you owed your old lender to the price of the vehicle you are going to purchase. If you owe $2,000 on your 2012 Ford Focus (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. Since the price tag on the 2017 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 you still owe $8,000 on your 2012 Ford Focus. 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 roll-over amount. If you were to take out a 60-month, 9-percent-interest car loan on the $14,000 Ford, 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 servicing a $16,000 loan instead. Given the same term, and at the same interest rate, your monthly payments would be $332, and the total interest you pay would be 3,920.
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 customer’s 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 2012 Ford Focus 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 2017 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 Ford 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 because it deprives you, the customer, of the opportunity to refinance the negative equity through other means.
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 don’t have to pay interest on the negative equity that would be rolled over into the new loan. If you don’t 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 to meet sales quotas and make room for newer models.
Many car dealerships promise to pay off your trade-in, 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 purchase. 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.