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
- Farah bought a car for $30,000 four years ago
- She financed it for $366/month over eight years years (96 months) at 3.99 per cent
- 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
- Because of her eight-year loan, Farah still owes $16,192 on her trade-in
- But because of depreciation and higher than average mileage, her trade-in is only worth $7,000 wholesale.
- Farah has $9,192 ($16,192 – $7,000) of negative equity
- So, Farah will need to borrow $44,192 ($9,192 + $35,000) to buy the new car
- 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.