If you're underwater on your car loan and your vehicle no longer works for your needs, you're probably uncertain about the next steps to take to get out of this predicament. The situation only gets worse if you can't keep up with the monthly payments or if your car needs costly repairs. Trading in a car that you're upside down on may be possible, but it also poses a risk of falling into a dangerous cycle of debt. Learn how to calculate your car loan equity, the options for trading in a car with negative equity and some alternatives to consider before you move forward with buying a new car and handing over your keys.
What is a Negative Equity Car Loan?
Having negative equity means you owe more on your car than its current market value. It's not an uncommon situation due to high depreciation and the increasing amount of debt borrowers are taking out to finance a vehicle. An average new vehicle loses 20% of its value in the first year of ownership and if the borrower didn't make a large enough down payment, they may be underwater the same day as they bought the car.
To calculate your car loan equity, take the amount you still owe on your car loan and compare it to the current estimated value of your car. For example, if you took out a $15,000 loan and still owe $10,000 on your vehicle, but the market value of the car is only $8,000, you have $2,000 of negative equity. Alternatively, if the vehicle's current value is $12,000, you have $2,000 of positive equity.
Although negative car loan equity won't always pose a problem, in certain cases, it can mean bad news for the borrower. If the vehicle is totaled or stolen, insurance will only cover the current value of the vehicle, forcing the borrower to fork up the difference. Another common scenario is that the monthly car payments become too high for the borrower to keep up and the value of the car isn't enough to pay off the entirety of the loan. Finally, serious mechanical issues requiring costly repairs can make owning the vehicle impractical. Negative equity means the borrower must be prepared to cover the difference out of pocket when they sell.
Trading In a Car with Negative Equity
Did one of the scenarios above describe your current situation? You're probably thinking about the best course of action. Trading in a vehicle with negative equity can be risky because it can start a spiral of debt that is difficult to crawl out of. We'll outline the options and what to be aware of when it comes to trade-in offers.
Your Trade-in Options
If you must trade in your vehicle while you have negative equity, there are several ways to move forward. You can pay the difference out of pocket, roll your equity into your new loan, or look for cars with significant rebates that land you in positive territory. The best option will be for you to pay off the negative equity when trading in the vehicle for something new. This allows you to get a clean start with an affordable car loan. Depending on how much negative equity you have, this option may not be plausible (for example, $5,000 may be hard to scrape up all at once).
Most of the time, the dealership where you go to buy a new car will allow you to roll the negative equity into a new car loan. If for example, your car is currently worth $8,000 and you have $2,000 of negative equity, the dealer may offer to pay off your loan, take your car and add the $2,000 into the amount of your new loan. Even if your monthly payments are lower when you purchase a more affordable vehicle, you'll immediately be underwater on your loan. Be wary of dealerships that advertise that they'll take a negative equity trade-in with "no strings attached". If the offer sounds too good to be true, it is. The balance will ultimately fall on your shoulders.
Trading In the Right Way
According to U.S. News and World Report, if you're forced to trade in a vehicle with negative equity, you should consider buying a car with a substantial rebate. If the rebate is larger than the negative equity you have on the vehicle you're trading in, you may be able to walk away with positive equity and much less of a headache. Keeping your loan terms short on the new loan (60 months or less) will also prevent you from being underwater on your car loan in the future.
Alternatives to Trading In
When you need to get out of a negative equity car loan, there are alternative routes you can take instead of trading in your car at the dealership. Usually, you'll be able to sell your vehicle privately for more than you'll get for it when trading in. Selling the vehicle and paying off the balance will give you a fresh start with no negative equity to weigh you down in the future.
If you can pay down the negative equity before selling or trading in the car, you'll be in a better position to finance or purchase a new vehicle. If you're looking to trade in because your monthly car payments are too high, another alternative is to refinance your car loan for lower payments or a lower interest rate. Refinancing allows you to keep the car you have but makes the loan payments more bearable. If you've improved your credit score since you purchased the car, there's a good chance you will be able to get a significantly lower interest rate.