If you’re financing an expensive asset like a car, you likely have some equity, particularly if you’ve made a down payment and have been keeping up with loan payments.
Unfortunately, there may be some cases where you may have negative equity, which essentially means you owe more on your loan than what your asset is currently worth. When this happens, you’re left financially vulnerable, with limited options available if you want to sell or refinance without incurring a loss.
It’s important to understand negative equity, how it can affect you, and what you can do to minimize the risk of this happening to you.
Key Points
- Negative equity means you owe more on your car loan than what your vehicle is currently worth.
- If you have negative equity, you may have trouble selling your car or refinancing the loan unless you can cover the difference.
- You can avoid negative equity by making a bigger down payment, paying a car in cash, buying a vehicle with a slower depreciation rate, leasing a car and choosing a shorter loan term.
What Is Negative Equity?
Negative equity means the value of an asset, such as a vehicle, is less than the remaining balance on the loan used to finance the purchase. Also referred to as being “underwater” or “upside down” on a loan, negative equity essentially means owing more on the loan than what the car is worth. This impacts the borrower’s ability to sell their car or refinance their loan.
How To Check If Your Car Has Negative Equity
To calculate if you have negative equity, you will need two pieces of information:
- Market Value Of The Vehicle. The market value is equal to the amount you would receive if you were to sell your car today. To find a reasonable estimate, do some market research on your vehicle using online resources like Auto Trader or Kelly Blue Book. It’s recommended that you get a second opinion, as the market value can vary.
- Outstanding Loan Balance. The amount you owe on your car would consist of a loan, lien or any other debt related to the asset.
Formula To Calculate Your Car’s Equity
Once you know the market value of your car and your total debt, you use the following formula:
| Market Value – Total Debt = Equity |
If the answer you get is negative, that means the debt exceeds the market value. In other words, you have negative equity in your car. Below is an example:
| Your Car’s Market Value | $5,000 |
| Remaining Loan Balance | $6,000 |
| Car Value – Loan Balance | – $1,000 |
In this example, you would have $1,000 negative equity in your car. That means if you were to sell your car today, you would need to come up with the extra $1,000 to pay off your car loan.
Understanding The Causes Of Negative Equity
Sometimes negative equity is a result of unexpected financial hiccups, while other times, it is a result of market conditions. Below is a list of common reasons for negative equity:
No Down Payment
Without a down payment, the total amount you need to borrow will be higher. This can increase your risk of negative equity because cars tend to depreciate in value very quickly, especially new cars.
Long Loan Term
Extending the loan term is great if you want lower monthly payments, however, you’ll be repaying the principal balance slower, which can cause negative equity. Ideally, it’s recommended that you get a car loan for up to 4 years and never more than 7 years.
High Interest Rate
A higher rate can reduce the amount of money that goes toward your principal balance. The high cost could work against you and possibly cause negative equity.
High Vehicle Price
When you’re out shopping, it’s easy to get caught up in all the bells and whistles. Sometimes this results in individuals purchasing something they can’t afford. This is especially true with cars. If you buy an expensive vehicle and its value depreciates faster than you can pay off your car loan, this may result in negative equity.
Rate Of Depreciation
Vehicles tend to lose value over time. However, the rate of depreciation may be faster or slower depending on several factors. For instance, new cars typically lose their value very quickly over the first couple of years. If you finance a vehicle with very little upfront and the car’s value depreciates very quickly, you could quickly find yourself in negative equity.
What Happens If You Have Negative Equity?
If you have negative equity in your car, you may face the following challenges:
Trouble Selling Or Trading In Your Car
While you can still sell your car or trade it in if you have negative equity, you’ll need to pay the difference between the loan balance and the sale price. This can prove difficult if finances are tight.
Limited Refinancing Options
Lenders often require a certain amount of positive equity to refinance a car loan. If you’re underwater on your loan, you might have a tough time qualifying for lower rates or better loan terms when refinancing.
More Money Paid Over The Long Run
Being in negative equity will make it more difficult for you to upgrade to a new or more expensive vehicle in the future. If you roll the negative balance into a new car loan, you may end up paying more in interest and extending your loan obligation.
Increased Financial Risk In The Event The Vehicle Is Totalled
If your vehicle is ever totalled and is unusable, you may file an insurance claim. However, the insurance provider will only cover you for the value of the vehicle. If you owe more than what the car is worth, you’ll need to make up the difference out-of-pocket.
Risk Of Repossession
If you’re having trouble keeping up with your car loan payments, you run the risk of defaulting on the loan. If this happens, the lender may take steps to repossess the vehicle to recoup their losses.
Learn more: How Many Car Payments Can You Miss Before A Repossession?
Can I Trade in My Car That Has Negative Equity?
Yes, you can trade in a car with negative equity. Keep in mind that you will still be responsible for paying off the outstanding debt on the old car. Dealerships tend to evaluate the equity of a vehicle that is being traded in and use the equity amount as a credit toward the new car’s purchase price.
If you have negative equity, you will owe the outstanding debts plus the new car’s price. To pay the negative equity debt, you can either pay it upfront or tack it onto the new car loan.
Learn More: Can You Trade In A Vehicle That Is Not Paid Off?
Strategies For Getting Out Of Negative Equity
It can be discouraging to find out that you have negative equity in your vehicle. The good news is that there are some strategies you can use to get out of negative equity:
- Make Extra Payments Or Increase The Payment Amount. The more you put toward your loan, the less you owe against the asset which increases equity, given that the market value stays the same. If you can afford it, putting more money towards the loan is a good strategy for eliminating negative equity, as long as your lender allows it.
- Refinance. Refinancing a loan can get you better terms than what you currently have. This includes a lower interest rate or a shorter loan term.
- Sell Your Car. This option also requires you to come up with the negative equity amount to pay off the remainder of your loan. However, if you can sell the car, you will be cutting your losses now and avoid getting into deeper negative equity down the road. If none of the above options will work for you, selling the asset and cutting your losses is likely the best option.
How To Avoid Negative Equity
To prevent a negative equity situation in the first place, follow these tips:
Make A Bigger Down Payment
The bigger your down payment when you first buy your car, the more equity you’ll have right off the bat. This lowers your risk of becoming underwater on your car loan in the future. It’s recommended to make a down payment of at least 20% of the vehicle price.
Opt For A Shorter Loan Term
The shorter your car loan term, the sooner you can pay off the loan. In turn, there will be less of a chance of having negative equity in your car. As mentioned earlier, a car loan term of 4 years is ideal, and never more than 7 years.
Buy A Vehicle With A High Resale Value
Certain vehicle makes and models retain their value better than others. Before buying a car, do some research on the current resale trends to help you pick a vehicle with a slower rate of depreciation.
Don’t Roll Over Negative Equity Into A New Loan
If you eventually trade in your car, try to pay off the outstanding loan balance before buying a new vehicle.
Make Extra Loan Payments
If your lender allows it, consider making an extra car loan payment every so often to reduce the principal faster.
Final Thoughts
Negative equity can be stressful and put you in a precarious financial situation. However, there are ways to fix the problem with dedication and the right strategies. Understanding its causes can even help prevent you from entering negative equity territory in the first place.
