Negative Equity: When You Owe More Than Your Car Is Worth

I’ve received this question twice in the past week: what do you do if you want to trade in your car, but owe more on the loan than what the car is worth? This is negative equity (or being upside down on your loan) and it’s becoming more and more common.

Negative equity graphic explaining how you can be upside down on a car loan

The old rule of thumb when buying a car

When it comes to car loans, traditional advice was to always put down at least 20% of the vehicle’s purchase price, and to finance the car over three to four years. According to Suze Orman, if you need to take out a longer term on a car loan to make the payments affordable, that car is out of your budget.

As of December 2019, the average price of a brand new vehicle was $38,948. Let’s apply this rule of thumb to a theoretical car loan for this amount, assuming excellent credit and a 4.25% interest rate. Before sales tax, you’d need to put down $7,790 up front, and your monthly payment would be $707 for 48 months, or $923 for 36 months.

Negative equity: becoming upside down

Following the traditional rule of thumb might not be feasible for many buyers. Maybe you need a large, dependable vehicle for your family, but don’t have $7,800 lying around for a down payment. Or maybe mortgage-esque monthly car payments just won’t fit into your budget. Maybe it’s both. So you lower the down payment, and you stretch the loan to a longer term. Suddenly your brand new car is depreciating much faster than you’re paying it off. You’re upside down.

You can have negative equity after purchasing a used car, but it is more common after purchasing a brand new vehicle. This is a result of how quickly a new car depreciates as soon as you drive it off the lot. Say you just purchased a compact SUV, a 2020 Kia Sportage, with an original purchase price of $25,490. You wanted to minimize your out-of-pocket expense, so you didn’t put any money down. You even rolled your sales tax into your loan. Using the Rhode Island tax rate of 7%, the total you’ll owe your bank on your Sportage is $27,274. Unfortunately, because of depreciation, even with barely any miles on it, Kelly Blue Book trade-in value on your like-new Sportage is only $17,667. Right off the bat, you have negative equity in your Sportage of $9,607.

What can you do about negative equity?

When you’re upside down in your car loan, there are three ways to address it. Two approaches require you to have the financial means to throw extra money at your vehicle, but one doesn’t.

1) Pay off your loan faster

This first approach requires you to have some room to play in your budget. If you have the means, you can eliminate your negative equity by paying off your loan balance faster. Paying more than your minimum monthly payment will help you hit the break even point in your loan more quickly. This is the point when you pay down the negative equity such that the amount you owe on the vehicle equals its value, and when you then begin to build positive equity in your car.

Depending on your lender, if you pay an amount above your monthly minimum, your bank may apply that overage toward interest and fees, and then toward your principal. Instead, you’re better off making a separate principal-only payment. Not only will you chip away at your negative equity, but you’ll also reduce the total amount of interest that you’ll pay over the life of your loan.

2) Pay off your negative equity at the point of purchase of a new car

If you’re upside down on your current vehicle and want to trade it in, and if you have the financial means, you can pay down your negative equity when you trade it in. Instead of arbitrarily throwing extra money at your loan principal, you minimize or eliminate your negative equity by essentially making a larger down payment on your next vehicle.

In the first approach, you work toward reaching the break even point over time through monthly and/or additional principal-only payments. But in this method, your objective is to modify your down payment on your new vehicle in such a way as to bring your trade in vehicle to the break even point in one fell swoop. You effectively pay off your negative equity all at once.

3) Roll your negative equity into a new car loan

Finally, this third option is your only choice if you can’t throw cash toward your loan balance. If you’re upside down, you can trade in that car and roll your negative equity into a new loan on a new vehicle. Because of how common negative equity has become, this is a scenario that dealerships encounter on a daily basis. But in the long term, this is the most expensive way to deal with your negative equity.

To illustrate this point, let’s go back to your 2020 Kia Sportage. Say you’ve owned it for a few weeks, but realize you need more room. Before you’ve even made any payments, you go back to the Kia dealership to trade it in for something larger. You select a Kia Sorento with a price of $29,890. Including sales tax on the Sorento, and your negative equity in the Sportage of $9,607, the total principal you’ll owe on the new Sorento will be $41,589.

But beware of the potential impact on your interest rate…

When your existing negative equity is added to the loan amount on a new vehicle, not only will your loan principal be higher than it would be otherwise, and not only will you therefore be paying more interest on that larger principal, but your interest rate may also be impacted as well.

Of the factors that a lender uses to determine your interest rate on a car loan, one is the loan to value ratio. This compares the amount of the loan to the value of the car that secures it. On your new Kia Sorento, if the total you wanted to borrow matched the value of the vehicle, maybe you could score a loan with a 4% interest rate. But now you’re asking the bank for $41,589 secured by a vehicle only worth $29,890. Your lender might require a higher rate as a result due to the less favorable loan to value ratio.

Proceed with extreme caution…

And, remember the concept of the break even point. Be sure that you plan to keep this second vehicle for a long time. With your existing negative equity from your first loan plus the depreciation of the new vehicle, your total negative equity on the new loan will be even larger than on the first. Depending on the loan term, hitting that break even point will take several years.

Comparing this option to the previous one, where you modify your down payment to minimize your negative equity, that approach is the better financial move. In that method, not only will you borrow less, but by manipulating your down payment you may also manipulate your loan to value ratio, which may result in a lower interest rate. Your dealership’s finance manager should be able to tell you what rate your lender will offer depending on the down payment amount.

How can you avoid negative equity all together?

Of course, it makes the most financial sense to avoid negative equity in the first place. Consider the following suggestions:

  • Make as large of a down payment as you can, or at least large enough to land the best possible interest rate.
  • Don’t stretch the term of your loan any longer than absolutely necessary.
  • Throw extra cash at your loan balance when possible. This keeps your vehicle’s value in balance with the remaining loan principal, while also reducing the total interest you’ll pay.
  • Keep your car for a long time. If not until it is completely paid off, then at least until you reach and surpass the break even point.
  • Purchase a late model used car to avoid new car depreciation. Especially if you like to drive something new every few years!

Employing as many of those tips as possible will help you stay right side up on your car loan.

If it’s time for a new vehicle but you’re concerned about negative equity on your existing car, let’s chat! Maybe it makes the most sense for you to wait until you’re in a more financially advantageous position. A vehicle is usually the second largest purchase that a consumer will make – these decisions shouldn’t be made lightly. But depending on your objectives, there may be a path forward that gets you into a newer vehicle sooner than you might think. I’m happy to run some numbers to determine the extent of any negative equity, and help shed light on your options. Get in touch!

Leave a Reply

%d bloggers like this: