What is negative equity? You have negative equity when your car's value is less than what you owe on your car loan. A negative equity car situation can develop in several ways. Fortunately, with a few smart moves, you can get out from under your upside-down auto loan position or avoid it in your next car purchase.
What Causes Negative Equity?
When you made a down payment and took out your auto loan for your new car purchase, the vehicle's market value was higher than the loan amount. Interest accrued as you made your monthly payments, increasing the total amount you had to pay on the loan. At the same time, the car's value was decreasing. If the car's Blue Book or market value drops below the total amount of principal and interest remaining on the loan, the result is a negative equity car. This condition is also called being underwater or upside-down.
The Negative Equity Car Problem
Being in an upside-down car loan becomes a problem if you need to pay your car loan off quickly and you realize the car is not worth the loan balance. Another negative equity car problem arises if you're involved in an accident and the insurance company writes your vehicle off as a total loss. You receive the car's value, but it's not enough to pay the loan. You're stuck with no car, yet you are responsible for the remaining loan. How did you end up upside-down?
A Low Down Payment Can Lead to Being Upside-Down
Making a low down payment contributes to an upside-down car loan situation. Combining a small down payment with an extended loan term increases the risk of being upside down on your new loan. If you buy a new vehicle for $30,000 and put only 5% down, which is $1,500, your loan amount before interest is $28,500. With a 60-month loan, your principal car payment is $475 monthly, before interest.
In the first 30 days after purchase, a new vehicle is likely to lose 10% of its value, which in this case is $3,000. So, by the time you're ready to make your first new car loan payment 30 days after your purchase, you're upside down on your loan. Your new car is worth only $27,000, and you owe $28,500, plus interest. You have $1,500 negative equity. In the first year after purchase, your car might lose 20% or more of its original value, which means by the end of the first year, your new vehicle might be worth only $23,000, but you owe $23,275, plus interest. The Kelley Blue Book trade-in value and resale value of your new car are likely to continue falling by 10% each year for the first five years after purchase.
A negative equity car has a loan-to-value ratio (LTV) of greater than 100%. If your vehicle is valued at $27,000 and your loan amount is $28,500, your car's LTV is 105.5% percent. Putting more money down when buying a new vehicle gives you smaller monthly payments, a shorter loan term, or both. Aim for putting 20% down when you buy a new or used car to help cover the depreciation for the first year. When you're paying a smaller loan amount off in less time, less interest accrues, and there's a lower risk of your car being worth less than the remaining loan amount. You will have a vehicle with an LTV ratio of less than 100%, which is what you want.
Interest Rates Matter in Negative Equity
When your car loan includes a high-interest rate, it contributes to the possibility of negative equity. Shopping around for low rates can help avoid negative equity, and credit unions are an excellent option for securing low-rate auto loans. If you authorize automatic withdrawals for loan payments from your checking or savings account, your credit union or bank may offer you a better interest rate than a car dealer, even if your credit score is not the best.
Rollover Loans Can Put You Underwater
If you had negative equity in your previous car loan and bought your current car with a rollover loan, you continued the underwater loan situation. Car dealers use the tactic of rolling an old loan balance into an existing loan when car buyers come in with negative equity. When you trade in a car every two years or so, you're creating an upside-down loan situation, because of the car's value decline and the more substantial portion of your monthly payment is going to interest, rather than reducing the principal. Keeping your car longer enables you to reduce your loan balance as the car's depreciation rate slows, so you create positive equity.
Why You Want Positive Equity
Positive equity is the opposite of negative equity. You have positive equity when your car's value is greater than the amount of your loan balance. Like home equity loans, positive equity in your vehicle gives you a resource from which to draw when you want to trade in your current vehicle and buy a new car. Car buying is more straightforward with positive equity than with negative equity, especially when you want to trade in a vehicle. If you owe $7,000 on your current vehicle and it has a Blue Book trade-in value of $10,000, you have $3,000 in positive equity, which gives you at least $3,000 toward the purchase of your next car.
Trading In Your Current Car With Negative Equity
While it's better to have positive equity in your current car if you want to trade in a car, it's possible to work a trade-in for a new or used car even though you're upside-down on your car loan. To find out exactly how much negative equity you have, subtract your current loan payoff balance from your car's current value. Contact your lender for your exact payoff figure, and check sources such as Edmunds and Kelley Blue Book for reliable car valuation. For the trade to work, you need to give the car dealer your current car and the amount of negative equity. If you owe $7,000 and your car's trade-in value is $5,000, you have negative equity of $2,000. You give the car dealer $2,000 cash and your $5,000 car.
Selling a Car to Get Rid of An Upside-Down Car Loan
Selling your car is an excellent way of eliminating your upside-down car loan. Put it in the best possible condition appearance-wise with proper washing, waxing, and detailing inside and out to attract buyers and bring the best price. Make sure your vehicle is in good mechanical condition, but don't spend a lot of money on things that won't bring you a return. Check with your lender to find out how to pay off the loan and get the title to the buyer once the deal is sealed. Do not accept a personal check or a money order from the buyer. You want cash or a cashier's check. If possible, take someone with you that you trust and meet the buyer at the bank.
Ways to Avoid Negative Equity Cars
In considering your next car purchase, avoid car loans that last more than five years. With a down payment of 20% or more and a loan term of 36 or 48 months, you're likely to build positive equity quickly. If you have bad credit, plan to improve your credit score. Pay off other accounts, make payments such as rent, mortgage, and utility bills on time, check your credit report for errors, and write letters to the credit bureaus to correct them. Taking these steps should raise your credit score and qualify you for lower interest rates, another way to avoid an upside-down car loan.
Be wise about the car you choose. Buying a used car may be the right move because it has gone through the new car depreciation cycle. Sites such as Edmunds and Kelley Blue Book provide accurate information about car makes and models that hold their resale value. In your research, pay attention to data about problems owners have reported as well as vehicle recalls by manufacturers.
If you have a negative equity car, you have options for getting out of the situation. With research and patience, you can relieve yourself of the burden and ensure your next car purchase keeps you right-side up in your car loan and on the road.