The negative equity loan, or balloon loan, is a subject of hot debate in the automotive world. Experts almost unanimously suggest staying away from these types of loans. The reasons why however still seem to be unclear in the minds of consumers. On the other hand, some sales representatives appear to strongly push their clients towards taking this type of loan in order to close a deal.
Note from the editor: The author of this article worked for two years as a sales representative for two different car manufacturers while at the same time completing his bachelor’s degree in Finance. He is currently still employed in the automotive industry and will begin a master’s in Public Accountancy in the fall.
If you are currently shopping for a new or used vehicle, you need to be aware of negative equity loans, what they are and what they mean. I am here to help!
First of all, what is a negative equity loan? Well there are a lot of definitions out there but here is a simple one: if you have a loan on a vehicle that exceeds the current resale value of your vehicle, you have a negative equity loan. Here is another definition, even simpler: if you cannot sell your current vehicle for enough money to get rid of your current loan on that vehicle, you have a negative equity loan.
They are not good and you should avoid them. When your vehicle is worth less than the money you owe on it, you are setting yourself up for problems. If you were to ever have that vehicle stolen, or totaled, your insurance might only give you the market value. Since the market value does not cover the loan, you will be left with a loan for a car, truck or S.U.V. you no longer have. If you were ever to lose your job or get injured and find yourself unable to cover your loan payments, you would not be able to get rid of it just by selling your vehicle.
Now that you know what a negative equity loan is and how dangerous it can be, let’s move on to how they are created: people who buy a new car when they still owe money on their current car.
I will let you in on a little secret: I have done this before. Actually I have done this twice. In the end, I found myself with a brand new car worth 35000$, but I owed the bank almost 45000$! That was before I began to study finance. Now, this same vehicle that was initialy worth 35k is now unfortunately worth, due to mileage and years, around 15000$. The good news in all of this is that I owe the bank nothing and my loan is paid off. A quick calculation shows me that had I not paid off my loan, I would still owe the bank nearly 30000$ on a car worth half that. You see, a vehicle’s value will depreciate faster than what you are paying on your loan. So over time, the gap between your vehicle’s value and the amount of money you owe on that vehicle will increase until you are 3 to 6 months away from paying off your loan. Basically, the situation goes from bad to worst.
Of course, the dealership that sold me that 35000$ car did not tell me this. When I bought the car new, I owed around 7000$ more on my trade-in that it’s actual trade-in value. No problem they said, they would simply tack on that extra 7000$ to my new loan and I could drive off with a brand new car. The best thing about it was that it only added about 100$ to my monthly payment. Given that I was well within budget for my payment, I figured this was a great idea. Well I was wrong. For the amount of money I was spending per month on this car worth 35k, I could have had a vehicle worth 50k! But even more problematic than that, I was setting myself up for an endless cycle of debt.
Dealerships will never tell you it is a bad idea to roll your old car loan into your new car loan. They will tell you that it is very common and reassure you that everyone else is doing it. The fact that you are considering it probably means that you hate your current vehicle or it simply does not fit your needs anymore. That means you will be easily convinced to have the dealership “take care” of your remaining car payments.
In some cases, dealerships go one step further and outright tell you that they will pay for your remaining car payments. Now, I do not want to break your heart if you think you negotiated this special favor, but the reality is that you did not. If you still owed 300$ a month for 6 months on your previous vehicle and the dealership told you they would cover them free of charge, then the dealer simply had a negotiation leeway of 1800$! They covered your remaining payments but most likely kept the sticker price of your new car intact. If someone walks into the same dealership tomorrow and asks for 1800$ off the sticker price of the same vehicle you have just bought, they will get it. However, their new vehicle will cost them less money than your new vehicle, even if both vehicles are the same! See the point?
The main idea here is that the dealership will take your remaining car payments or loan balance and add it to the price of your new car,truck or S.U.V., effectively giving you a negative equity loan. You are left in a situation where you are paying for two vehicles when you only have one in the driveway.
How can you avoid this? Well there is only one way really. You must absolutely wait until your current vehicle’s value becomes equal to your loan balance before changing it. Ideally, you want to wait until your loan is completely paid before changing your vehicle but sometimes that is not possible. In the case of a lease, you are pretty much stuck with it unless you get someone else to take your lease from you. If you owe more money on your vehicle than what it is worth, or you still have lease payments to make, you should not buy a new car.
Now, I would be remised if I did not point out one very small and rare exception to this rule. I had a client who was paying an annual percentage rate (APR) of almost 8% for a car loan that he had contracted when he was in a tough financial position. Things were better for him now and he could qualify for a 1.9% APR loan. He owed around 2500$ more than the market value of his current vehicle. Simple calculations showed us that it was actually a good idea to roll that extra 2500$ into a loan with significantly lower interest payments and buy a new car now. He ultimately ended up saving money. So in this case, it was not a bad idea. Notice however two key points: 1) the gap between what he owed to the bank and his current vehicle’s value was small and 2) there was a huge gap in interest rates. In this seldom seen situation, he made the right move. If your situation meets the above points, you might consider rolling your existing loan into a new car loan. However, I would strongly recommend you check with a financial advisor or planner before visiting your dealership!
So here is what you need to remember:
A) When dealerships take over your remaining car payments or loan balance, they are creating a negative equity loan.
B) Negative equity loans create a cycle of debt where you are stuck with your loan, no matter what happens to your car.
C) You should not buy a new car if you owe more on your current vehicle than its market value.
D) If you are not finished with your lease, your only solution is to find someone to take over your payments. Do not have your dealership cover them because you will be paying them anyway.
If you require further information on this article or any other automotive topic, please do not hesitate to ask our auto experts!
The Auto Consultants