The Pitfalls of Rolling In Negative Equity
Hello there, fellow car owner! Or maybe soon-to-be car owner? Whatever the case, this guide should be helpful to you if you’re the kind of driver who likes to trade in their cars or are thinking about trading in their car.
I highlighted this in my first real post on this blog but I think it’s time to expand upon why it is such a terrible idea to roll negative equity into the next car you trade in for. But first, let’s go over the anatomy of a car loan and how trading in works.
Lifting the Hood of the Financials
When you finance your car, you’ll see the following financial information:
- The total amount financed
- Annual Interest Rate (APR)
- Length of the loan (months)
- TTL (Taxes, Title, & License) fees
- Other fees/services (insurance, options, etc)
A lot of this info (specifically the info related to the loan) must be provided to you thanks to the Truth In Lending Act (TILA). Probably the most important piece of info is the APR, as it will play a large role in how much you’ll end up paying (in interest). The APR you receive is gonna depend on a number of factors, including your credit history, the lender you go with, your credit score, etc. The higher your APR, the most interest you’ll pay on the loan.
One piece of info that isn’t immediately thought of (or is ignored) is the car’s value. It’s a fact: cars depreciate as soon as you take it off the lot. A car’s value is affected by its age, condition, among other factors but also how it’s sold/traded-in (more on that in a bit). Newer cars have a higher rate of depreciation, which slows down as the car gets older. It’s one of the reasons many financial experts advise against buying a car brand new. Confession time: the car I currently drive (a 2014 Toyota Corolla)… I bought that brand new.
If you’re the kind of person to keep their car until it’s paid off and/or you drive it “into the ground” (i.e., keep it for a very long time), that car’s value won’t matter that much to you. However, if you’re one of the folks who likes to trade-in their cars, then this is going to matter… a LOT.
“Underwater”
When you go to trade-in your car, the expectation is that you can apply the money equating to the car’s value to the car you plan to purchase. However, and increasingly so, buyers are finding that the equity in their car is actually in the negative. How is this so?
In the car sales industry, it’s called being “underwater” and occurs when the amount owed on the car is greater than the car’s value. That difference is called “negative equity”, and when you have negative equity on a trade-in, it can make thing a little bit trickier.
One way that auto salespeople and lenders have come up with to overcome this issue is to allow potential buyers to take the negative equity (the balance owed) and add it to the amount you will finance on the new car. This is called “rolling in” negative equity and it’s one of the worst financial decisions you can make.
Why? Let’s go over the reasons below.
The Problems With Rolling It In
I’m just gonna list them out really quick.
- The new car loan costs more.
- Higher monthly payment.
- Immediately underwater.
- A limit to how much and how often you can roll in negative equity.
It goes without saying that rolling in negative equity immediately makes the cost of the new car more expensive AND raises your monthly payment. Here’s an example below.
Say you have a car you’re looking to trade in (car A). You owe roughly $25,000 (3.11% APR, 60-month period, $450/month) but it’s worth about $20,000. You’re looking to trade it in for a car (car B), which costs about $15,000 (includes TTL). Your hope in trying to trade down is to lower your monthly payment. Problem is, you have $5,000 of negative equity. If you were buying the car without trading-in, the car would cost roughly $15,000 (3.11% APR, 60-month period, $270/month).
If you were to roll that $5,000 in, the loan for car B would be roughly $20,000 (3.11% APR, 60-month period, $360/month). The new car would be a little more expensive than if you were just buying it for the first time.
Okay, that’s a little more expensive than you were thinking, but you say, “at least it’s cheaper than what I am paying now”. Au contraire, dear reader, there’s one potential issue with trying to go down in car: LTV (loan-to-value ratio). Long story short, lenders aren’t going to be willing to roll negative equity into an older vehicle OR a cheaper vehicle. Why? Well, it has to do with the loan compared to the value of the car. Car A has an LTV of 125% ($25,000/$20,000*100%). If you tried to trade that car in for car B, it would have an LTV of 133% ($20,000/$15,000*100%), and lenders typically want to avoid an LTV over 125% on a loan.
The result is that you’ll end up going UP in car, which would mean a higher monthly payment, and more expensive car loan, and being deeper underwater. Enter car C, which will cost about $25,000 (includes TTL). If you were to roll that $5,000 in, the loan for car C would be roughly $30,000 (3.11% APR, 60-month period, $541/month).
Rolling in negative equity (in that example) drove the monthly cost from $450 to $541 (yikes). Keep in mind that on this new car loan, the LTV will grow as the car depreciates, and when you go into the dealership to try this again, the lender may not approve the loan on the trade-in. Why? Well, the LTV of car C at the beginning of the loan will be 120%, but after the depreciation (25% in the first year, per this calculator), the car might be worth around $22,500, at which point, the LTV might be around 126%. This would be a bit too high for lenders to consider another trade-in, and at that point you’ll be stuck with the car and the loan.
The numbers used here are rough (and more or less pulled out of my ass) but the examples follow what normally happens on trade-ins with negative equity. Don’t believe me, then I would check out the excellent car sales subreddit. Ok, call up your car salesperson or lender and ask them.
Definitely consider the potential costs down the road (pardon the pun) if you are looking to trade-in and are underwater on your car loan. Luckily, I also wrote briefly about how to tackle this situation.
