*Insert toothy, shark-like, salesman smile.* That’s a pretty good deal they’re dangling in front of you. You have a vehicle that you still owe $10k on, and frankly, you’re tired of it; it’s breaking down, it’s too banged up, or it’s just yesterday’s news. It’s time to upgrade! Why should you pay off that loan if these kind salespeople will do it for you? They’re such generous people.
I hate to be the bearer of bad news, but the dealership is not paying off your trade-in. That is YOUR debt, you signed for it, and you will still be paying for it. Dealerships don’t care how much you owe because they’ll wrap up the previous loan with your new loan and present you with a giant new bundle of debt. You’re now paying for two auto loans at one time. The balance of the loan on the trade-in still exists, and the dealer is not going to absorb the debt for you.
Let’s break this down. The dealership advertises that they will pay off your trade. This is very enticing, and you head down there to check out their selection of cars. You pick out a car and hand over your trade-in to the dealer; you sign it away. Then, the dealer takes you to the room where you complete all the paperwork. In that paperwork, they have added the balance of your previous loan to the balance of the new vehicle you purchased. Now, they finance the entire lump sum. For example, you have a trade with $10,000 left on the loan. You purchase a new vehicle for $20,000. The dealer takes the $10,000 and adds it to the $20,000 and then finances your loan for $30,000. So, did the dealer pay off your trade? Well, they used a new loan to pay off the old loan, but they did not remove the debt you owe. You now owe interest on a $30,000 loan for a vehicle that is worth $20,000. The dealership got a nice trade-in that they can recondition and sell for a nice profit. Now, how do you like that?
Congratulations! You are the proud owner of Negative Equity! In the case of purchasing a vehicle, negative equity is when the value of the vehicle you purchased is below the amount of the loan you used to purchase it. In other words, you took out a $30,000 loan to pay for a vehicle that is only worth $20,000. This is also described as being “upside-down” or “underwater.”
Unfortunately, many people are in this situation. If this has happened to you, you are not alone. The dealer understands that most people read, “We’ll pay off your trade,” as “we will acquire your debt.” They push the paperwork quickly in front of you, and your emotions are so high about purchasing that new vehicle that perhaps you don’t look over every document carefully. This happens often, but here’s how to avoid it and get out of it. Prepare yourself, because this might hurt.
Pay off your car loan. When purchasing a vehicle, make sure that the trade-in vehicle is paid off completely or the loan amount is so low that the value of the vehicle is more than the balance, e.g. the vehicle is worth $5,000 and you owe $2,000 on the loan. You can get an estimate on the value of your vehicle by checking websites like Kelley Blue Book (www.kbb.com) or NADA Guides (www.nadaguides.com).
Make a down payment. By this, I mean you should typically put down about 20% of the loan. I understand that it is not always an option, but it will help to keep you from becoming upside down in your loan. Small down payments often mean that you will owe more than the value of the vehicle as soon as you drive off the lot.
Larger payments, shorter loan. I DO NOT encourage you to sign for a loan that you simply cannot afford. Not being able to meet your monthly car payment will lead to devastating consequences. However, you should find the most you can spend per month and opt in for a shorter loan term. Shorter loans typically offer lower interest, and you own the vehicle outright in a shorter amount of time. Adding additional payments to the principal will also reduce the amount you owe on the vehicle, thus the value of the vehicle will eventually be more than the balance on the loan.
Refinance. Perhaps you didn’t choose the best loan option while you were at the dealership or your credit has improved since then. If that is the case, refinancing the loan could help your wallet immediately and for the future. Refinancing occurs when you take your current loan to another financial institution, who will pay off the previous loan, and give you a new one with better terms. This can provide lower interest rates, lower monthly payments, and even a shorter loan. Of course, read all loan agreements before you sign to ensure you are getting the best deal.
Don’t be discouraged. Take small steps in the right direction, so that you can become a savvy shopper. And, remember, when a deal sounds too good to be true, it is.
–Thanks to Karie Austin for writing assistance