Negative Equity Explained

What is Negative Equity?

Negative equity means that the value of an asset is less than what you owe on its loan. This means that if you need to sell the vehicle before you have equity, the sale of the car won't cover the remaining balance of your loan.

Negative equity is common, and it often occurs upfront, but levels out as you repay the loan, bringing the car's value and the loan balance in line. Some common causes of negative equity include depreciation, making a small down payment, setting up too long a loan term, and rolling over negative equity from a previous loan.

Here's an example of how a loan term can impact negative equity:

With a loan term of 24 months, you are paying off about 4% of the loan principal every month. If a new car depreciates 25% in the first year, you have covered that amount during the first six months of the loan. After that, you are in an equity position on the car, or your loan balance is less than the value of the car.

On the other hand, with a 60-month loan, you are paying only 1.5% of the loan principal every month. With no down payment, it would take almost 17 months to hit the 25% depreciation mark, and by that time, the vehicle is well into its second year of depreciation.

As you can see, extending the term puts the car owner into a downward spiral of depreciation that takes longer and longer to overcome in the payment cycle. It therefore follows that the longer the loan term, the longer the “window” of a negative difference between the car's value and the balance of the loan will exist.

Causes of Negative Equity in Auto Loans

Negative equity has many causes when it comes to a car, not the least of which is depreciation. Vehicles are depreciating assets, which means they lose value over time with use. Here's a breakdown of what may cause your car to have negative equity.

Depreciation

Depreciation happens quickly and automatically, and a vehicle can lose as much as 10% of its value as soon as you drive it off the lot. Typically, a new car in the U.S. depreciates an average of 15% to 20% a year for the first five years of ownership. The biggest dip, however, happens in the first year.

Making a smaller down payment

Making a down payment, especially a substantial one, can help curb depreciation's effects on a vehicle since it lowers the amount you're borrowing. The more money you put down on a car, the less you will owe over time. If you don't make a down payment or only make a small one, you will owe more on your loan.

Choosing a long loan term

Choosing a longer loan term means paying more on your car in interest charges, and if your loan term is too long, you could increase your chance of negative equity. This is because at the beginning of a loan, more of your payments go toward interest, and less toward decreasing your principal loan amount.

High interest rates

Higher interest rates mean more money owed over time, so it can be harder to tackle your principal loan balance, driving up your risk for negative equity.

Rolling over negative equity

If you've had negative equity in the past, sometimes a lender will allow you to roll this over or add it to the balance of your new loan. This is a good idea in theory, but it makes it harder and harder to combat more negative equity the more you do this.

Overpaying

Sometimes vehicles are sold for more than their market value, due to dealership markups, add-ons, or simply luxury vehicles that don't hold on to much value. This is a surefire way to owe more for a vehicle than it's worth.

Damage

If there is an accident or natural disaster that damages your vehicle, you may end up with negative equity due to damage that brings down your car's value quickly. This can be especially true if the damage isn't repaired or if the vehicle isn't insured for enough to cover the damage. To mitigate this cause of negative equity, it's a good idea to have GAP insurance.

How to Get Out of a Negative Equity Auto Loan?

If you're upside down on your car loan, one of the easiest ways to beat negative equity is to wait it out. eventually, you will pay enough on your loan that the balance is less than the value of you're vehicle. But what if you can't wait?

Some best practices for getting back into an equity position on your vehicle mean taking extra steps to bring the balance, whether this is by making extra payments on your loan or trading in your car.

Typically, the easiest way to get out of a negative equity situation is to pay more on your car loan whenever you can. Whether you do this by paying multiple times a month or by making a lump sum payment that's larger than normal. By bringing down the amount you owe, you can tip the balance in your favor. By doing this, you also pay off your loan earlier and save money on interest charges.

Best Practices for Avoiding Negative Equity

To avoid negative equity, you can take steps to keep the equity in your car, or you can combat it from the start.

• Use a large down payment. A larger-than-required down payment can diminish the amount you borrow, putting you in a better position from the start. A good down payment is a great way to battle initial depreciation.
• Choose the shortest loan term you can afford. Choosing a shorter loan term makes your payment go up, but more of your money will go toward the principal balance sooner with a shorter term, helping you avoid negative equity.
• Buy a vehicle that holds its value. Cars and SUVs from manufacturers such as Toyota, Honda, or Subaru tend to have better resale value since they are known to hold their value longer than other vehicles. A muscle car or certain luxury vehicle may not hold on to as much value over time.
• Opt for a lower interest rate. If you can, rate shop to find the best deal before you agree to the first loan you're offered. Be sure to negotiate any dealer markups, check for unneeded add-ons, and shorten your loan term to see if you can get a lower interest rate.
• Avoid getting stuck on the trade-in treadmill. When you roll negative equity forward into your new loan, you're starting with even more negative equity than normal. Therefore, the best way to avoid this is not to roll over negative equity. Avoid trading in vehicles without equity, or wait until you've paid more on your loan to make a trade.

The Bottom Line

Negative equity is best avoided, but sometimes, it's unavoidable. The good thing is that negative equity doesn't typically stick around forever, and once your vehicle is paid off, its entire value becomes equity you can use toward something else.

If you're worried about negative equity, know that there are steps you can take to help yourself get out of the position and into an equitable loan.