Negative Equity – The Loan that Never Ends

When you bought your last vehicle, chances are good you took out a loan. Whether you accessed your personal line of credit, started a term loan at your bank branch, or used the dealership’s financial services manager to shop the car loans available in the store, odds are, you didn’t pay cash.

What’s more, a full 57% of car loans started last year (2012) were for six year terms or longer. Amid the economic crunch, car buyers have shifted their focus to incorporate the “carrying” costs of their vehicle; as disposable income amounts drop, people search for ways to lower their fixed monthly expenses to keep up. By stretching out the amount of time you take to pay back a loan on your car, you artificially lower the cost of owning it, on a monthly basis, even while you drive up the total cost of ownership by paying heftier interest over the longer term.

It seems like a good idea, reducing the monthly cost, until you consider the fact that many people do not keep their vehicle for the full duration of their loan. Some people find their needs change (for example, they have a baby) or they are involved in a serious collision or other accident that leads to their insurer “writing off” the vehicle. In general, most people owe more on their loan than their car or truck is worth, for most of the time they are paying for the vehicle. Any time you are on the hook for an asset that is worth less than the amount still to be paid, you are in a position of risk. With negative equity on your car loan, you jeopardize your ability to sell the vehicle without digging into cash reserves to offset the difference between what you owe and what the car is worth. So what seems like a smart way to stretch extra money each month is actually more like playing the lottery with someone else’s money.

So how do you know if you are in a negative equity position on your vehicle? Here’s the two most common scenarios:
A couple finds out they are expecting a baby. Suddenly, the sports coupe they bought eighteen months ago seems impractical. They visit their local dealership, find a small crossover utility vehicle that will hold strollers, playpens and whatever other things they need to tote, and negotiate a price that fits their budget.

Things are going well, until it gets time to appraise the sports coupe for a trade in value. He tells the salesman they need $18,000 to pay out their bank loan, and that’s what they want for the car as a trade. After a formal appraisal and market evaluation, the sales manager puts a value on the vehicle of $11,000. The couple are told they can either pay out the rest of the bank loan themselves, or apply to have the $7,000 in negative equity carried forward on their new loan. This method adds about $80 a month to the payment they had just worked out. It makes the new vehicle something that doesn’t fit the soon-to-be-reduced budget of their soon-to-expand family.

On another day, a recent school graduate is driving his car to work. It’s a modest vehicle, but he just bought it last year, so it has lots of cool options and tech features that he likes. The payment fits his monthly budget, which is important because he just started his first job six months ago and it doesn’t pay what his university professor said he would eventually make. He comes to a red light, puts on his right turn signal, slows to a stop, and then advances since the coast appears clear. He doesn’t see the drive out access from the coffee shop drive thru just on the other side of the light, and that driver has the right of way on a green light and is looking down moving stuff to fit her coffee into her cup holder. When she hits his car, he has almost straightened out from his turn, but the left rear quarter of his car is crunched, and her SUV has hit him at over 50-km/h, leaving his two drivers side doors crumpled and causing his airbag to deploy.

The insurance company gets the repair estimate of $8500, and figures out that since the vehicle is only worth $9000 now, they will just “write off” the vehicle instead of fixing it. They write a cheque to the bank which holds the car loan for $9000. Trouble is, there is a total of $13,700 still outstanding on the loan. The young driver has no idea where he will get $4,700 and also afford to put a down payment on a replacement vehicle.

Negative equity affected about 30% of vehicle traded in at dealerships during the month of October 2012, according to research firm JD Power and Associates. Add to that the unfortunate insurance situations like the one above, and it is easy to see why negative equity could be considered the single biggest, preventable risk facing car owner today.
Protect yourself from acquiring negative equity by these three simple steps:

Choose a termed car loan rather than a line of credit. Studies have shown that nearly every time, people do not make the same amount of payments on a line of credit, and that in many cases; they never actually pay off the line of credit fully. A termed loan forces you to make regular payments so not only do you pay off the principal but you limit the amount of interest you pay over the time you own the car.

Pick the shortest term you can afford. Think realistically about what you will do with that extra $25 a month you “save” by selecting a 72 or 84 month term, and then think about what you could do with the money you actually save in interest, not to mention the savings of having a vehicle you still want to drive without having any payments to make. Just one year of driving a paid off, middle of the road vehicle could allow you to save up $5000 using the amount you would have paid, plus you can save a little over $1000 in interest payments by choosing a five year loan instead of a six year term.

Ask about GAP insurance. GAP is the commonly used name for Guaranteed Asset Protection, and it is an insurance product that will cover some or all of the difference between the amount your insurance company would pay if your vehicle were written off and the amount you still owe on the loan. It can be financed over the term of your loan, and will add only a few dollars to your payments, but can save you big, with some policies covering as much as $30,000 in negative equity.

If you already have negative equity, and you need to sell your vehicle, there are a few steps you can take to limit the financial impact of your situation:

Do your market research and figure out exactly what your car or truck is worth. Don’t accept less than market value for your vehicle, because this leaves you scrambling to pay off an even bigger lump sum. CarBuyCo Canada uses nationwide data in specialized software which tracks the market selling prices of all vehicles sold at ADESA Auctions across Canada. Relying on a number based on market driven data, like the value offered by CarBuyCo for your vehicle, will ensure that you get paid actual fair market value.

Plan ahead. If you know you will need a new vehicle in, say six months, call your bank and ask for your “payout amount”. This might also be available on your online banking profile. Do some research and figure out your vehicle is likely worth, and spend the next six months making a dent in the difference. A few hundred dollars here and there can add up over a little bit of time.

Be reasonable when you select your next vehicle. If you have to carry forward some negative equity, it is doubly important that you find a vehicle that is priced very well against the rest of the market. Make a compromise: pick a slightly higher kilometer vehicle, or take a color that maybe you don’t prefer, if you can save a few thousand dollars. If you aren’t careful, you can make your situation more serious by adding your old negative equity in to a losing ratio on the new vehicle, to the extent that, at some point, banks will not advance enough money secured against the vehicle as an asset to cover the money you owe on car(s). Then you will be forced to borrow some other way or put up cash out of pocket.

Find out what your car or truck is worth, and sell it for fair market value with the help of CarBuyCo. Our expert Purchasing Agents use market based software to generate purchase offers based on what cars like yours are actually selling for, across Canada, every day.