Most people know the effects of having negative (upside down) equity, especially after seeing the housing market crash and realizing homes were worth less that the mortgage owed. However, many people do not understand how negative equity affects their current and future car purchasing decisions.
Many customers base their decision on the selling price of the vehicle and negotiate as if they are paying cash at the time of sale, even though they are a payment buyer. Other customers base their decision solely on the lowest monthly payment and the minimum down payment. In reality, most customers finance their vehicle and really should base their decisions on the monthly payment and necessary down payment after taking into consideration the vehicle’s estimated future value and loan payoff amount throughout the term of ownership.
Obviously, it is better when the value of the vehicle is equal to or greater than the loan payoff amount throughout the time of vehicle ownership. This is when the initial down payment, trade-in vehicle equity (positive or negative), selling price, monthly payment, interest rate, term of contract and type of vehicle come into play. Your vehicle’s trade-in value to a dealership should be the same amount they would be willing to write you a check for, even if you decide not to purchase a vehicle from them. If your vehicle’s value is less than the bank or financing institution’s loan payoff (negative equity, often referred to as “upside down”), then you will have to come up with the difference. That difference or rude awakening happens when the customer begins shopping for another vehicle or if the vehicle is totaled in an accident.
For example, say your vehicle is totaled. The insurance company values your vehicle at $15,000, sending the financing institution a check for that amount. Since you owe $5,000, the bank looks to you, the owner, to pay the difference. Coming up with $5,000 on demand can be very frustrating and always untimely. Similarly, if you are purchasing another vehicle and owe $5,000 more than your vehicle’s actual trade-in value, your financing institution carrying the first loan wants the entire balance to be paid off before it will release ownership of your vehicle for the trade-in. So, your options are to pay off the $5,000 negative equity to break even, finance an additional $5,000 beyond the purchase price of the new vehicle or a combination of the two.
How did this unfortunate financial reality come about? Most likely, it started when you purchased your trade-in vehicle several years prior. You may have been upside down on the previous trade-in and wanted to have a low or no down payment. You also wanted a low monthly payment so the term of the loan may have been extended possibly with an increase in interest rate. Perhaps you paid too much for the vehicle or the vehicle lost value due to recalls, market demand and supply, economic conditions, vehicle condition, prior accidents, etc. In reality, what really caused this negative financial condition started long before you began shopping for another vehicle.
Now, fast forward. You want to purchase another vehicle and have negative equity (upside down) of $5,000. You want an upgrade but the same vehicle new is now more expensive and you are $5,000 upside down. To achieve the same prior monthly payment and similar terms of the prior transaction including a similar down payment, you must settle for a new or newer vehicle that is less expensive, probably smaller and has fewer options than your current trade-in vehicle.
Now reality sets in, and you become frustrated at the dealership’s trade-in offer, selling price, terms offered and the sales consultant going back and forth between managers. Sometimes the dealership’s management team has not been transparent or has not been able to explain your situation and how you got there. They are too focused on just selling the car. Sometimes the dealership will extend the contract terms/months in order to fit the monthly budget. This just postpones the time when the customer will be faced with the same or even worse situation. Either way, the customer is faced with resolving the $5,000 in negative equity.
The most satisfied customer is one who is informed and asks questions. Purchasing a vehicle is a major financial decision that can impact your current and future financial situation. A dealership should discuss with you how to resolve your current negative equity issues before selling you a car. A transparent dealership will be pleased to offer you the pros and cons of your purchasing decision, because ultimately, a long-term, trusting relationship should be everyone’s goal.
By Alan Chan