Negative equity on an auto loan can happen for a variety of reasons, and it can become a headache if you’re trying to sell or trade in your vehicle. However, you can work through negative equity, and there are even some ways to avoid it altogether.
Common Negative Equity Causes
You can only have negative equity on a car that you’re financing. Negative equity happens when the vehicle isn't worth as much as what you owe on its loan. A quick example: if you have a $10,000 auto loan balance, but the car is only worth $8,000, you have $2,000 in negative equity.
There are three main causes of negative equity, which can combine to make a perfect storm – and you don’t want to be in the eye of it. Three main causes of negative equity are:
- Taking out a long loan term
- Having a high interest rate
Deprecation never stops, and it’s what lowers your vehicle’s value over time. New cars lose their value very quickly, typically anywhere from 10% to 20% within the first year of ownership. In fact, as soon as you drive your new vehicle off the dealer’s lot, it loses value immediately.
After a few years, deprecation slows down. Cars tend to see their biggest drop in value within the first five years. Because of this, it’s generally recommended that borrowers with lower credit scores finance used vehicles. Which brings us to the other causes of negative equity: loan terms and interest.
The longer you stretch your loan, the more you risk being in a negative equity position. Factoring in interest charges (which are typically higher for people with poor credit), the higher the interest rate you qualify for, and the longer your auto loan, the more you risk placing your car in a negative equity position.
If you must take out a longer loan term, then you’re risking putting yourself in a negative equity position because interest accrues daily based on the balance of your loan. The longer it takes you to pay off, the more you pay in interest. If your payments can’t knock down what you owe on the loan as fast as depreciation is shaving off your vehicle’s value, it can lead to owing more on the car than it’s worth.
Issues That Come With Negative Equity
Having negative equity at the beginning of an auto loan is common. It typically only causes issues when you want to sell or trade in your vehicle.
If you owe more on the car than it’s worth and can’t get an offer that covers your loan balance, you’re going to be stuck with negative equity when it's time to get your next vehicle. This means either paying for the remaining loan balance out of pocket or rolling the balance into your next auto loan.
Another headache of negative equity can be experienced if something happens to the car. Because auto insurance only covers the value of your vehicle, not what you owe on your loan, a theft or accident could mean you’re stuck paying off the negative equity even after losing your car.
Getting Rid of Negative Equity
If you stay current on your vehicle payments, time and patience could be the cure for negative equity. Once your loan is paid off, or you catch up to the value of your car, then you’re in the clear. If you start to miss payments, you not only risk defaulting on the loan, but also losing ground on keeping up with deprecation.
Another solution for negative equity is just paying for it out of pocket. Some borrowers who get windfalls of cash, like a tax refund, pay off their negative equity right then and there.
You can also make extra payments or pay a little extra each month. Every little bit can knock down your loan balance, and help you get a little closer to an equity position over time.
Avoiding Negative Equity the Next Time Around
Negative equity often happens to borrowers when they first take on an auto loan – especially with a new vehicle. One of the best ways to combat negative equity is to be proactive and use a down payment.
It’s typically recommended that borrowers who are financing a new car put down 20% of the selling price. Since new vehicles can lose around 20% of their value in the first year of driving it, that down payment can really help avoid negative equity before it becomes a problem.
For used cars, it’s generally recommended (and sometimes required if you have bad credit) to put down at least 10% of its selling price. Used vehicles may depreciate slower, but they still lose value over time – mileage, wear and tear, and time all contribute to your car losing value.
You can also try to avoid negative equity by working to qualify for the lowest interest rate you can, and taking out the shortest loan term you can afford. More interest charges mean more cash tacked onto your loan, increasing the amount you owe every day. Longer loan terms mean more interest charges, and paying off the vehicle slower – making it hard to keep up with deprecation.
Ready for Your Next Auto Loan?
If your car is at risk for negative equity, or you’re already knee-deep in it, it may be time to get into another one that can hold its value. However, when you have less than perfect credit, getting into a vehicle can be easier said than done – but it doesn’t have to be hard when you team up with us at Auto Credit Express.
Over the years, we’ve created a nationwide network of dealerships that are signed up with bad credit auto lenders. We want to match you to a dealer that can work with your credit. To get started on your next car loan, complete our free auto loan request form.