It’s common to take out a loan when you buy a car, whether it’s a new or second-hand vehicle. But there are some things it’s helpful to make sure you completely understand before you do so, including the potential for negative equity.
You might have heard this talked about in relation to housing in the past. People who buy a house with a small deposit can end up with a mortgage that is more than their house is worth, if values drop. The same can happen with a car loan. Here’s why it matters and what you need to know to avoid or manage it.
What is negative equity in a car loan?
Negative equity refers to a situation where your loan balance is more than the car is currently worth. This is sometimes called being “upside down” on a car loan.
It is quite common, and maybe more prevalent than you realise. It can happen quite easily because vehicles tend to depreciate quickly as the years go by, particularly when they are new or nearly new. If your car is new or nearly new, the fastest depreciation often happens at the time when any loan balance is likely to be falling more slowly, too.
How does negative equity happen?
Your new car generally drops in value the minute you drive it away after you purchase it, particularly if it’s a brand-new vehicle. It also then declines in value through the first few years. Some estimates are that the value of a new vehicle can drop 30 percent a year in the first year. Secondhand cars also depreciate, but generally don’t have the same initial value drop.
Not all cars depreciate in the same way, and those that are more expensive or have a reputation for being unreliable could depreciate more quickly. In general, though, the value of your car will drop significantly in the first few years and then less quickly on an ongoing basis.
If you’ve taken a loan, this may also be a period where more of your repayment is going towards interest, leaving less to reduce the principal. Your loan is decreasing at a slower rate; at the same time, your car is depreciating more quickly, which can easily put you in a situation where you owe more than the car is worth.
Loan structure and your approach to lending have an impact, too. This is particularly the case if you’ve bought a car with no deposit, or a low one, or you have a long loan term, as the principal reduces more slowly.
A balloon payment structure, where you pay a lower repayment through most of the loan and then a bigger payment at the end, can also easily create a negative equity situation because you’re generally not knocking down the loan balance much until the end of the loan term.
If you have rolled existing debt into a new car loan, you could also end up with a larger loan compared to what the vehicle is worth.
A simple example of negative equity
Here’s an example of how it can work.
You buy a car for $30,000 with no or a minimal deposit:
After two years, the car’s value drops to $22,000, but you’ve only paid the loan principal down to $26,000. This means you’re $4000 in negative equity.
Why is negative equity a problem?
You might think this isn’t a big deal – you’ll pay off your loan over time, so the situation will eventually come right. To some extent, that is true. As long as you are happy with your vehicle and you can make your repayments, negative equity is a temporary thing that will come right, at least by the end of your loan term (unless it’s a balloon payment, in which case there is the potential for negative equity still)...
But there can be situations where it becomes a problem.
It might limit your ability to sell or trade in your car
If your circumstances change and you decide to sell or trade in your car, owing more than it is worth might limit your options. You will need to factor in what you do about the additional amount you owe, as part of any calculations of the affordability of your next vehicle.
Makes refinancing more difficult or expensive
If a lender thinks that a loan is risky, it can be harder to borrow or might attract a higher interest rate. If you are looking for a new lender or want to renegotiate the terms of your loan with your existing lender, you might find that your car being worth less than your loan is a hindrance.
It might make your loan for your next car larger
Sometimes, people who are buying a new vehicle while in negative equity solve this by adding the additional amount onto their new loan. This can work, but it means your borrowing is larger than it might otherwise be. This increases the risk of negative equity on your next purchase. The more often you do this, the more you end up owing.
It could cause stress if your circumstances change
While negative equity often isn’t a problem while you’re paying off your loan, it might be a headache if something happens that puts your ability to make repayments in jeopardy. If you were to lose your job or otherwise experience a drop in income, not having the ability to clear your loan by selling your car may be an issue.
Negative equity and different loan features
The type of loan you choose can affect your chances of ending up in negative equity.
Here’s what you need to know:
Longer loan terms
If you have a loan that is over a longer term, maybe five years or more, you’ll be paying off less of your principal with each repayment in the initial years. More of your payment goes on the interest cost for a longer time. The shorter your loan term, the faster your principal is repaid and the higher the chance that your loan drops more quickly than the value of your car.
Balloon payments
Balloon payment loans can have a number of risks, including the potential for negative equity. A balloon payment is a significant sum that is paid at the end of a loan term. The repayments until that point are much smaller than a loan that does not have a balloon payment, which means the loan balance does not drop as much.
Adding on to your loan
If you’ve added warranties, insurance, or other costs to the amount you borrow, the loan will start off higher compared to the value of the car, creating more opportunity for a negative equity situation.
New vs used cars and negative equity risk
New cars are more prone to depreciation than secondhand vehicles. When a car is new, the minute you drive it off the yard it stops being “new” and the premium that a buyer would pay to be the first owner is gone. That means buyers need to factor in a sharp drop in value at the beginning of their loan term.
Used cars can depreciate more slowly, although there is usually still more depreciation in the first few years than in the later years of ownership. Your vehicle’s reputation for reliability and how sought-after it is by other buyers will also determine how fast its value drops.
This isn’t to say that buying new doesn’t make sense – many people value the new technology that is available with new cars, particularly if they are purchasing an electric vehicle, and the warranties that come with buying new. You might also plan to own the car for a long time and find it makes sense to buy new. In those situations, you can build the negative equity risk into your planning.
How to check if you’re in negative equity
If you are wondering whether you might be in negative equity, there are a few things you can do.
The first is to find your current loan balance and verify how much you still owe.
Then you need to estimate the car’s market value. You can do this by looking at listings of similar cars for sale, or asking for a trade-in estimate from a dealer.
Then you compare the two figures to see whether your loan is larger than the value.
If you’re concerned about what you discover, you could get in touch with a financial adviser, such as the team at better finance™, to talk about your options.
What can you do if you’re already in negative equity?
There are a few things you can do if you discover you owe more than your vehicle is worth.
Carry on
If the car repayments are manageable and you’re happy with your vehicle, the right option might be to do nothing and wait for the balance to drop to the point you are no longer in negative equity.
Consider making extra repayments to reduce the balance faster
If you’re worried about negative equity and you have the ability to make more repayments, you could reduce your balance more quickly this way. It may pay to check whether this will mean you are charged any additional fees.
Refinance cautiously
You may be able to secure a new loan or restructure your loan with your existing lender to allow you to pay your loan off more quickly. This might be with a lower interest rate, for example, or a shorter loan term.
Avoid upgrading too early
A potentially reliable way to avoid negative equity is not to buy a new car too often. Paying your loan down, or even off, and then not upgrading until you have a larger deposit can protect your equity position.
How to avoid negative equity when taking out a car loan?
There are a few ways that you might be able to avoid negative equity from the outset.
Put down a larger deposit if possible.
The bigger your deposit, the less you’ll need to borrow and the lower your chance of negative equity.
Choose shorter loan terms.
When you are paying off your loan more quickly, you have a greater opportunity to stay ahead of the drop in value of your vehicle.
Avoid balloon payments unless they are well planned.
When you take out a balloon payment loan, it’s important to understand how this will work in a number of ways. You’ll need to know how you’re going to cover the final payment, and what the structure will mean for your loan balance in the meantime.
Don’t borrow more than the car’s long-term value supports.
If you know your car is likely to drop in value quickly, it may make sense to try to limit how much you borrow for the purchase.
Rather than new, consider nearly new or used vehicles.
You may find that a car that is a year or two old is in virtually the same condition as a new vehicle, but does not have the “new car” premium to lose.
Negative equity and life changes
Negative equity usually only becomes a big problem when something happens in a borrower’s life that brings it into focus. With all borrowing, it’s helpful to think about how you would cope with a change in your situation. If you no longer had your job, would you be able to service the loan? If your income changed, do you have a backup plan?
Sometimes, the change can be for positive reasons. Maybe you have a growing family and need to swap your vehicle for something bigger. You might own a business and need to upgrade or change your vehicle. In these scenarios, you may need to plan for how you’ll pay off any residual loan left over after the sale of your current vehicle. In some cases, it may work to hold off on the change a little longer to allow the loan to drop further.
Frequently Asked Questions (FAQs)
Is negative equity common in NZ car loans?
Yes, it’s common for borrowers to find that, for some of their loan term, their loan is larger than the value of their car. This is because the car may depreciate more quickly than the loan balance falls.
Can I trade in a car with negative equity?
This can be possible, depending on whether you meet the lending criteria. However, we do recommend you have a plan for how you’ll cover any shortfall. We can help you look at your options.
What risks come with trading in a car with negative equity?
You may need to borrow more for your next vehicle than you otherwise would have.
Does negative equity affect my credit score?
No. As long as you’re making your repayments, your credit score is not affected.
Can insurance cover negative equity?
The amount your car is insured for usually decreases over time, according to the market value of your car. For a while, you could find that this is less than you owe. If you are borrowing to buy a car, you might be able to take out guaranteed asset protection (GAP) insurance, which can help in situations where your car is written off, and the insurance payout does not clear the loan.
How long does it usually take to get out of negative equity?
It depends on the structure of your loan. If you’re paying it down quickly, you might find the negative equity situation does not last long at all. But if you’re paying it off more slowly, you might be in that position for longer.
How can leasing a new car help manage negative equity?
When you lease a car, you don’t own it at all. You’re paying for the ability to use it. This means you don’t have a negative equity situation, because you don’t ever have equity in the car at all. If you’re someone who upgrades frequently, leasing may make sense, but it tends to be a more expensive option for most people.
Like to talk?
If you have any questions about any aspect of vehicle finance, get in touch with the team at better finance™. We’re experts when it comes to personal loans.
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