What Happens If You Sell Your Car for Less Than You Owe?

It is common for individuals to find themselves in a situation where they need to sell their car, but the outstanding loan balance is greater than the vehicle’s market value. This scenario is often referred to as “negative equity” or being “upside down” on a car loan, meaning the car’s worth has fallen below the amount still owed to the lender.

Understanding Negative Equity

Negative equity arises when the current market value of a vehicle is less than the remaining balance on its auto loan. For instance, if a car is valued at $15,000 but the loan payoff amount is $20,000, there is $5,000 in negative equity. This imbalance develops due to several common factors that influence a vehicle’s value and loan structure.

One primary cause is the rapid depreciation of vehicles, especially new ones. A new car can lose a significant portion of its value, often between 15% and 25%, within the first year of ownership alone, and continues to depreciate thereafter. This initial sharp drop means the car’s value decreases faster than the loan principal is paid down, particularly in the early stages of the loan.

Another contributing factor is the increasing prevalence of long loan terms. Longer terms extend the period before equity builds, resulting in slower principal reduction and allowing the car’s value to decline further before the loan balance catches up. Additionally, making a small or no down payment means financing a larger portion of the car’s initial value, immediately placing the borrower in a position where the loan balance can exceed the car’s depreciated value. Rolling over negative equity from a previous car loan into a new one also exacerbates the problem, as it adds an existing deficit to the new vehicle’s financing, making it harder to achieve positive equity.

Financial and Credit Implications

Selling a car with negative equity means the borrower still has an obligation to the lender for the difference between the sale price and the outstanding loan amount. This remaining amount is known as a deficiency balance. If this balance is paid promptly and according to the lender’s terms, the impact on an individual’s credit report can be minimal.

If the deficiency balance is not addressed, the financial consequences can be significant and detrimental to one’s credit standing. Failing to pay the remaining debt can lead to late payment notations on credit reports, which lower credit scores. As the debt ages, the lender may escalate collection efforts, potentially selling the debt to a third-party collection agency. A collection account on a credit report is a negative mark that can remain for up to seven years, further damaging creditworthiness.

If the debt remains unpaid, the original lender or the collection agency might pursue legal action. A successful lawsuit can result in a court judgment, which allows for remedies such as wage garnishment, bank account levies, or liens on other assets, depending on state laws. A damaged credit history from unpaid deficiency balances, collection accounts, or judgments can make it more difficult to obtain new credit, including future car loans, mortgages, or personal loans, and may lead to higher interest rates or stricter loan terms for any credit that is approved.

Addressing the Deficiency Balance

When faced with a deficiency balance after selling a car for less than owed, individuals have several options, each with distinct financial implications. The most straightforward approach, if financially feasible, involves paying the difference directly to the lender. This action immediately resolves the debt, preventing any negative credit reporting and allowing the individual to move forward without further obligation. This method results in the least impact on one’s credit profile.

Another common strategy involves rolling the deficiency balance into a new car loan. This means the amount owed on the previous vehicle is added to the financing for a new car. While this can provide a way to acquire a new vehicle without an immediate out-of-pocket payment for the old debt, it increases the principal of the new loan. Consequently, the new loan will have higher monthly payments and accrue more interest over its term, potentially extending the period of negative equity on the new vehicle.

Negotiating with the original lender presents another avenue for resolution. Borrowers may be able to reach a settlement agreement where the lender accepts a lump sum payment less than the full amount owed, or they might agree to a structured payment plan. While a settlement can resolve the debt for a reduced amount, it may still be reported to credit bureaus as “settled for less than the full amount” or “partial payment,” which can have a negative, though less severe, impact on credit scores compared to a full default. Establishing a payment plan helps avoid collection activity and legal action, as long as payments are made consistently.

As an alternative, some individuals might consider taking out an unsecured personal loan to cover the deficiency balance. This separates the old car debt from any new vehicle purchase, offering a clear path to repay the specific amount. Personal loans carry higher interest rates than auto loans, especially for individuals with lower credit scores, which can increase the overall cost of the debt.

If the deficiency balance is ignored, or none of these methods are pursued, the consequences escalate. The debt will likely be sent to a collection agency. If collection efforts fail, the lender or agency may file a lawsuit, potentially leading to a court judgment that could result in wage garnishment, bank account freezing, or property liens, depending on state laws and the legal process.

Tax Considerations

If a lender forgives or cancels a portion of a deficiency balance, this canceled debt may be considered taxable income by the Internal Revenue Service (IRS). For instance, if a borrower owes $5,000 but the lender settles for $2,000, the $3,000 difference could be viewed as income. Lenders are required to report canceled debts of $600 or more to the IRS and to the borrower on Form 1099-C, “Cancellation of Debt.”

There are exceptions that might exclude some or all of the canceled debt from taxable income. One primary exception is the “insolvency exception.” This applies if the borrower’s total liabilities, including the canceled debt, exceed their total assets immediately before the debt cancellation. If a borrower can demonstrate insolvency, the amount of canceled debt that can be excluded from income is limited to the extent of their insolvency.

Specific rules and calculations for the insolvency exception can be complex. Other exceptions may also apply depending on the circumstances, such as cancellation of qualified principal residence indebtedness or certain student loan cancellations. Given the intricacies of tax law, particularly concerning debt cancellation, individuals who receive a Form 1099-C should consult a qualified tax professional. A tax advisor can assess the individual’s specific financial situation, determine if any exclusions apply, and ensure proper reporting to the IRS.