With Americans taking more than $50 billion in auto loans per month, it’s vital to understand what negative equity is on a car and how to avoid it.
So, keep reading to find out more!
What Is Negative Equity on a Car?
Essentially, negative equity on a car is when you owe more money on your car loan than the car is worth. For instance, if the car is valued at $12,000, but you own $16,000 on the car, you have negative equity of $4,000.
To find out if you have negative equity, simply subtract what you owe on your car loan from the current market value of the purchased car. If the number is positive, you have positive equity. If the number is negative, you have negative equity.
Why Do I Have Negative Equity on My Car Loan?
Some reasons why you might have a negative equity car loan include:
You Don’t Put Down Enough Money
When you buy a car, the vehicle can lose up to 20% of its value in the first year. As a result, if you don't put enough money down on your vehicle loan, you'll likely have negative equity. Even during your initial year on a vehicle loan, expect to have negative equity if you make a small down payment.
You Put a Lot of Wear and Tear on Your Vehicle
Another factor that could lead to negative equity on your car loan is putting a lot of wear and tear on the car. Naturally, if you use your car a lot or don't take care of it, it will lose value over time. This can lead to negative equity on a car since the vehicle’s amount will have depreciated in its value.
For instance, exceeding the miles on the car causes the car to drop in value, so it’s important to know what is considered a good mileage limit.
You Have a Long Car Loan Term
While it’s great to have more time to pay off the car, the longer you finance your car, the more time there is for the car to lose value. Consequently, if you have a long car loan term, you're more likely to have negative equity.
In the past few years, car term loans have become increasingly common. Therefore, sometimes, it’s better to look at the difference between buying and leasing a car and make a wise decision depending on your finances.
How Can Negative Equity Affect Me?
With 88% of Americans owning a car, having a negative equity car loan or being upside down on your car loan might put that 88% in a financial bind.
Here are some things that can happen if you have negative equity:
The Next Car Loan Could Be More Expensive
One way negative equity can affect you is that if you want to get a new car loan, the interest rate could be higher. That's because the lender will see that you still owe money on your old car and will factor that into the new loan.
In the end, if you decide to roll over the balance of the current auto to your new car, you may end up borrowing more money than the vehicle is worth, immediately putting you in an upside-down scenario.
Selling Your Car Could Be Difficult
Another way having negative equity on a car can affect you is that if you want to sell your car, you might not be able to. You will need to find a buyer willing to pay more than what you owe on the car loan, and many decide to pay only within the fair market value range.
You Could End up Making Payments on a Totaled Car
One of the most stressful ways negative equity can affect you is if your car gets totaled in an accident. If this happens, you could end up making payments on a car that no longer exists! Not to mention, you would also need to find a way to get a new car.
You can only get rid of the negative equity by fighting an insurance company over a totaled car or getting a collision or comprehensive coverage before, so you can be prepared if such a thing happens to your car.
How Do You Avoid Negative Equity?
There are a few simple methods to avoid negative equity on your auto loan.
Put a Larger Down Payment
You need to understand how much negative equity will bank finance, which is usually 125%of the car’s value. To avoid negative equity on your vehicle, you can make a larger down payment when purchasing it.
A larger down payment will help reduce the chance of being upside down on your loan. It's best to put 10% or 20% of the total car's price or as much cash as possible if you cannot afford to put that much money on a down payment.
Choose a Shorter Loan Term
Additionally, you can choose a shorter loan term. The shorter the loan term, the less time there is for the car to lose value. As a result, you're less likely to be upside down on your loan.
Consider Obtaining GAP Insurance
GAP coverage is worth having if you want to avoid negative equity on your car loan. In cases where you have regular coverage when the car is totaled or stolen, you are usually left with negative equity since the insurance pays only a sum of the car’s current value, leaving you in a tough situation to pay for the difference. But if you have GAP coverage, the difference will be paid for.
How Does Negative Equity Work With a Trade-In or Selling a Car?
If you're looking to trading-in a car with negative equity or sell it, the process can be a little more complicated.
When you are looking for a replacement, the dealer usually gives you an offer lower than what you owe on your loan because the dealership will need to pay off the remainder of your loan. As a result, you would still owe money on your car even after trading it in.
The same goes for selling your car. While the current statistics on used cars show that the used car market has taken off, you need to find a buyer willing to pay more than what you owe on your loan. If you can't find a buyer willing to do this, you have to pay for the difference yourself.
Bottom Line
In short, negative equity can be a tricky situation to be in. But if you're aware of the risks, you can take steps to avoid them. And if you find yourself with negative equity, in this article, we defined what negative equity is on a car and how to deal with it, so it won’t be that much of a problem.
