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Thinking about trading in your car and buying a new one? Before you head to the dealership, learn how negative equity can turn a new car loan into a much bigger bill than the sticker price.
What Is Negative Equity on a Car Loan?
The Wall Street Journal recently reported on how more and more consumers are going upside down on their car loans. The article follows an electrician who signed up for four auto loans in two years. Each time he traded vehicles, he rolled the unpaid balance into the next loan. The latest was a Jeep Cherokee with a sticker price of $27,000. His loan was $45,000 once it was all said and done.
This phenomenon, known as negative equity, can leave borrowers feeling trapped. With the costs of vehicles rising, the affordability gap is now filled with vehicle loan debt. It’s easier to get a new car with a low or no down payment and terms that can last seven years or some cases longer. But the problem is that most people do not keep their cars for the whole term. They are still responsible for the remaining debt on the vehicle when they trade it for a new one.
Here’s how it works:
When subsequently buying another car, borrowers can roll this old debt into a new loan. The lender that originates the new loan typically pays off the old lender, and the consumer then owes the balance from both cars to the new lender. The transactions are often encouraged by dealerships, which now make more money on arranging financing than on selling cars.
It’s not that buyers are trading for fancier cars. Many times it’s because their needs have changed like an expanding family or something is wrong with the vehicle mechanically.
To add insult to injury, many of the borrowers who have negative equity, have lower credit scores which increase interest rates making an average car even more expensive.
What Happens When You Default on a Loan?
If you have rolled in your negative equity into a new car loan, your payments are higher on the new vehicle than what the car may be worth. And if you total the new vehicle or it breaks down, you are in real trouble. Let’s say you crash the car. Insurance is only going to pay what the car is worth, not what you owe on the loan. If you stop making the payments because you can’t drive the car, you default on the loan. Thus, further decreasing your credit score and increasing your interest rates.
Should you roll negative equity into a new car loan?
Sometimes you have no choice, but try these options first:
- Buy a used car or a less expensive model. (See our new vs used guide)
- Choose a shorter loan term. Long terms feel affordable but delay building equity.
- Get pre-qualified before you visit the dealership so you know your rate and budget.
- If you can keep the car, refinance for a better rate and a shorter payoff.
- If nothing is wrong with the car, keep making payments until the loan is paid off, then shop.
If you drive for Uber or Lyft, also compare insurance costs and check whether gap coverage makes sense while you owe more than the car is worth.
Wrapping it Up
The bottom line is, when deciding to whether or not you should purchase a new car, only you know what is best. Be realistic about what you can afford, and the realities of keeping a car for the life of extended loan terms.
This article is for informational purposes only and rideshareguru.com does not make any guarantees to its accuracy as each state’s insurance situation is unique. We recommend that you contact a licensed insurance agent for the most accurate information regarding your coverage.
Sarah Ware (CISR) holds licenses in Property and Casualty as well as Life and Health insurance and has worked in the insurance industry for over 10 years.
