Can You Trade a Car With Negative Equity?

It is possible to trade in a car even when the amount owed on its loan exceeds its current market value, a situation known as negative equity. Dealerships often facilitate such transactions despite the financial complexities. Understanding how negative equity impacts a vehicle trade-in is important for consumers considering this option.

Understanding Negative Equity

Negative equity occurs when the outstanding balance of a car loan is greater than the vehicle’s actual market value. It is also called being “upside-down” or “underwater” on a car loan. For example, if $15,000 is owed on a vehicle that is only worth $10,000, there is $5,000 in negative equity.

Factors contributing to negative equity include rapid depreciation of new vehicles, often losing as much as 20% of their value in the first year, which can outpace loan balance reduction. Small or no down payments also increase the likelihood of starting a loan with negative equity. Extended loan terms, such as six or seven years, slow equity accumulation. Additionally, rolling prior negative equity from an older vehicle into the current loan can perpetuate the cycle.

How Trading with Negative Equity Works

When trading in a vehicle with negative equity, dealerships handle this by incorporating the deficit into the new car loan. This is known as “rolling over” the negative equity. The outstanding negative balance from the old loan is added to the purchase price of the new vehicle, increasing the total amount to be financed. For instance, if a car has $3,000 in negative equity, and the new car costs $25,000, the new loan would effectively be for $28,000 plus any additional fees and interest.

This approach allows consumers to acquire a new vehicle without immediately paying the negative equity out-of-pocket. Dealerships process such transactions and work with lenders to structure the new loan. However, the total amount of negative equity that can be rolled over depends on the buyer’s creditworthiness, the value of the new vehicle, and the lender’s policies, with some lenders financing up to 120% to 130% of the new car’s value. Consumers should carefully review all loan documents to understand how the negative equity is applied and its impact on the new financing terms.

A less common, but direct, method involves the buyer paying the negative equity difference directly to the dealership at the time of trade-in. This clears the old loan completely, allowing the new car purchase to start without an inherited debt. While this option avoids increasing the new loan amount, it requires the consumer to have the necessary funds readily available. Some dealerships may also offer incentives or discounts on the new vehicle that effectively absorb a portion of the negative equity.

Financial Considerations of Trading with Negative Equity

Rolling over negative equity into a new car loan has financial consequences. The most immediate impact is a higher principal balance on the new loan than if the trade-in had positive or zero equity. This increased principal leads to higher monthly payments, making the new vehicle less affordable. To mitigate higher monthly payments, consumers might opt for a longer loan term, extending payments over six, seven, or even eight years.

Choosing a longer loan term can result in paying more interest over the life of the loan. This extended repayment period also means it will take longer to build positive equity in the new vehicle, potentially perpetuating the cycle of being “upside-down.” If the new car also depreciates rapidly, the consumer could quickly find themselves in a negative equity position on the new loan as well. If the new vehicle is totaled in an accident, insurance payouts are based on the car’s market value, which may not cover the full loan balance including the rolled-over negative equity, leaving the owner responsible for the difference unless Guaranteed Asset Protection (GAP) insurance was purchased.

Alternatives to Trading with Negative Equity

For individuals facing negative equity who wish to avoid rolling it into a new loan, several alternatives exist. One approach is to pay down the negative equity on the current vehicle before initiating a trade-in. This can involve making additional payments towards the loan principal, which reduces the outstanding balance and helps build equity faster. Before doing so, it is advisable to check if the loan has any prepayment penalties.

Another option is to sell the car privately rather than trading it in at a dealership. Private sales often yield a higher price than dealership trade-in offers, which can help reduce or even eliminate the negative equity. If the private sale price is still less than the loan balance, the seller would need to pay the remaining difference to the lender to close the loan. This method allows for greater control over the selling price and can provide more funds for a down payment on a new vehicle.

Waiting to trade until the car’s value increases relative to the loan balance is a strategy. Continuing to make regular loan payments will gradually reduce the principal, eventually bringing the loan balance closer to or below the vehicle’s market value. This allows for a trade-in when positive equity has been established or negative equity has been significantly reduced, avoiding the financial pitfalls associated with rolling over debt.