Trading in a vehicle with negative equity should be avoided and this situation can be made even worse if you are attempting to finance your next vehicle with a bad credit auto loan.
Speaking from experience
At Auto Credit Express we've been dealing with credit challenged consumers for the last 20 years. During that time, we've helped thousands of these consumers raise their FICO scores and reestablish their car credit by financing a vehicle with a bad credit car loan. We have also tried our best to educate regarding what a very different kind of finance instrument a bad credit auto loan really is.
Along the way, we've noted the increasing number of customers that are “buried” in their trade-ins due to negative equity.
What is negative equity?
Negative equity is a term that is used when the value of an asset that is used to secure a loan is worth less than the loan balance. This happens when the asset depreciates faster than the loan value is being reduced. In the automotive business, this meaning is applied to a car that appraises for less than what the customer owes the bank or leasing company.
The history behind negative equity
Since the 1950's, banks and other lending institutions have been extending the number of months that consumers can finance an automobile. There are two major reasons for this:
Cars became increasingly more expensive and in order to secure business banks offered longer loan terms in order to make the monthly payments more affordable. Since banks compete against each other for business, the lower monthly payment usually wins and the easiest way to get there was to increase the term.
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% the first year, you have covered that amount during the first 6 months of the loan, so after that you are in an equity position on the car.
With a loan term of 60 months, 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.
A last resort
It only makes sense to roll negative equity into a new car if you have no other alternatives. What you are essentially doing when you finance a new car with negative equity from your old car is paying for two cars at the same time – your old car's negative equity plus your entire new car.
For customers who are credit challenged, this situation is compounded by the fact that the interest rates on bad credit car loans can be much higher than a traditional loan. This means that these consumers are paying a high interest rate on two cars, not just one.
Doing something like this only makes sense if the car you are currently driving is not reliable, if you have a cash down payment that will help offset the negative equity, or the new car you will be buying has much better gas mileage or qualifies for better auto insurance rates that will help offset what is certain to be an increase in your monthly car payment.
Bad credit car loan lenders
What a bad credit lender will do really depends upon the situation. Most subprime lenders use either Kelley Blue Book (out west) or the NADA guide (in the east) as a benchmark. Lenders will usually allow the dealer to sell a used car for anywhere from 90% to 115% of trade-in value listed in the book or a new car for 90% to 110% of invoice price.
Can the dealer do it?
Again, it depends on a number of things. If the difference between the dealer's selling price and 115% (or less) of the trade value covers the negative equity, the dealer should be able to accommodate you. If there isn't that kind of profit in the deal, you can either try and negotiate a lower price or switch to a different vehicle. If you're looking at a new vehicle and the manufacturer is offering a rebate in the form of customer cash, there may also be a chance that you can use this type of rebate to offset all or part of your negative equity.
On the other hand, if you have too much negative equity in your current vehicle, there may be no way that the dealer can help you get out of your car or truck.
As we see it
It's never a good idea to roll negative equity from one car to another. Because of the high interest rates common with bad credit car loans, the results can be especially painful. In many cases, only a large cash down payment can decrease the amount of negative equity to the point where you can trade in your current vehicle.
For nearly 20 years, Auto Credit Express has been helping people with credit problems get approved for new and used car loans. Our affiliate dealers work with the leading subprime lenders to get you approved. Your credit report will get checked by the dealer, but once you're approved, each month you make your car payment you are rebuilding your credit score and reestablishing your financial future.
Visit www.autocreditexpress.com to see what we can do for you.