What happens when you get negative equity?
4 October 2023
By Joy Pearson
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When venturing into the world of car finance, one term that can make a significantly difference in your financial journey is 'negative equity'. This concept, often referred to as being 'upside down' on your car loan, can have substantial implications for your financial health and your ability to secure favorable terms on future car purchases. In today's post, we'll thoroughly explore what negative equity in car finance means, how it works, and what steps you can take to navigate this financial landscape effectively.
Negative equity in car finance is a situation where you owe more on your auto loan than the actual market value. Put simply, it's when you're financially 'underwater' with your car loan. This predicament typically occurs then the rate of depreciation of your vehicle outpaces your loan repayment efforts.
One of the primary contributors to negative equity is the rapid depreciation that many cars experience, particularly within the first few years of ownership. New vehicles, especially those in the luxury category, often lose a significant portion of their value shortly after leaving the dealership lot. This depreciation can be a double-edged sword for car owners, as it can lead to negative equity if not managed properly.
Let's break it down with an example: Imagine you purchase a brand-new car for £30,000, using a finance plan. After a few years, the car's market value has plummeted to £20,000, but your remaining loan balance stands at £25,000. In this scenario, you find yourself in a negative equity situation of £5000 because, if you were to sell the vehicle, you'd need to come up with an additional £5000 to pay off the loan fully.
One of the primary drivers of negative equity is the rapid depreciation of a vehicle. Most cars, especially brand-new ones, experience a significant drop in value within the first few years of ownership. This depreciation can outpace your loan repayment efforts, leaving you owing more than the car's current worth. You might also find that longer term loans can make monthly repayments more affordable, but they also increase the risk of negative equity. When you opt for an extended loan, you might struggle to keep pace with your car's depreciation. Consequently, you could find yourself in a negative equity situation for a more extended period.
Rolling over the outstanding balance from a previous car loan into a new one is another factor that can contribute to negative equity. While this may seem like a convenient way to manage debt, it can add to the amount you owe on the new loan, especially if the previous car's value had depreciated significantly.
Understanding the implications of negative equity is crucial for making informed decisions in your car finance journey. When you have negative equity, selling your car can be challenging. The amount you owe on the loan may exceed the car's market value, making it difficult to cover the loan balance with the sale proceeds. This can limit your options if you need to get rid of the vehicle. Negative equity can also lead to higher monthly payments. This occurs when you roll over the unpaid balance from a previous loan into a new on or when the depreciation rate outpaces your payments. As a result, you'll be paying more each month to bridge the gap between the loan balance and the car's value.
Ultimately, negative equity in the car finance industry can arise due to rapid depreciation, extended loan terms, and rolling over balances from previous loans. It's implications include limited selling options, increased monthly payments, and challenges in obtaining favorable terms for a new car loan. Being aware of these factors and their consequences is crucial for making informed decisions on the world of car finance.