What is Negative Equity?

How does negative equity happen?

• If you take out a three-year loan when purchasing a vehicle, the monthly payments will be very high
• If you take out an extended-term loan lasting between six and nine years, the monthly payments become more affordable
• However, by the time you pay off your loan, your car may have significantly depreciated in value, and you now end up owing more for a car than what it’s worth
• If you plan to keep your vehicle for a long time, depreciation may not be a problem.
• Over time, your needs may change since you first made your purchase. You may want to trade it in for another car before you’ve finished paying off the loan, resulting in heavy additional costs.

Negative equity example

1. Farah bought a car for $30,000 four years ago
2. She financed it for $366/month over eight years years (96 months) at 3.99 per cent
3. Farah drove her car 140,000 km over the last four years: now she wants to trade it in on a new car costing $35,000
4. Because of her eight-year loan, Farah still owes $16,192 on her trade-in
5. But because of depreciation and higher than average mileage, her trade-in is only worth $7,000 wholesale.
6. Farah has $9,192 ($16,192 – $7,000) of negative equity
7. So, Farah will need to borrow $44,192 ($9,192 + $35,000) to buy the new car
8. Her monthly payment will increase to $538.

In the example above, Farah will owe nearly $45,000 for a $35,000 vehicle, a vehicle that will begin depreciating as soon as she takes delivery. Obviously this scenario leads to a higher monthly payment and increased borrowing costs. When you then consider the snowball effect of negative equity, it’s a borrowing technique that could eventually prove disastrous.

A common problem

Apparently more than 50 per cent of car buyers with trade-ins have negative equity. Before agreeing to an extended term loan for a vehicle purchase car buyers should educate themselves and consider the following:

 1. How much do I drive?

• • Think about how frequently you drive
  • Greater mileage will depreciate your car faster, hurting its trade-in value
  • If you take an extended-term loan, it may mean you have to delay your next purchase until you’ve fully paid off the vehicle

 2. How long will I keep this vehicle?

• • Take a moment to consider if the length of time you plan on keeping this vehicle works with the timeline of your loan
  • If you only plan on driving this vehicle for a short time, it may not be smart to take an extended-term loan

 3. How fast will this car depreciate?

• • Keep in mind the car will depreciate as soon as new vehicle is driven off the lot
  • Ask the dealer how quickly the car will depreciate
  • If you’re frequently driving a car that depreciates quickly and you plan on keeping the vehicle for only a few years, you should think very carefully about taking on a long-term loan

Other considerations

• • Regularly trading in to have a newer car can start a financing cycle where frequent loans must be taken for the new vehicle, including the funds needed to pay off a loan
  • If you have to make an insurance claim, your insurer will only pay for the value of the vehicle, not the negative equity – GAP (guaranteed auto protection) insurance is available to secure the balance (additional cost)

For more information about long-term auto financing and negative equity view the resources below.