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Understanding Negative Equity—the Dangers of Being a Monthly Payment Junkie

Negative Equity

Vehicles that would have been completely unaffordable two decades ago are now financially accessible. Many consumers can buy the car of their dreams, with no money down, for a monthly, bi-weekly (or even daily) payment that has somehow become “affordable.” But how? Did cars get cheaper? Are we all significantly wealthier? Or is something else at play?

For many, this is a direct result of historic low interest rates combined with extended repayment terms (e.g. 84-96-108 months). Not long ago, 48-60 month car loans were the norm. Today, it’s common for consumers to finance their vehicle over seven or eight years. That’s a significant length of time for a product that begins depreciating the second it’s driven off the lot. It is not without risk.

Consumers who purchase a vehicle based on low payments due to extended-term loans are sometimes referred to as Monthly Payment Junkies. These car-buyers often don’t understand that long-term vehicle financing can set up a cycle of greater and greater debt with subsequent vehicle purchases. Increasingly, consumers are finding themselves “upside-down” when it’s time to trade in and purchase another car.

Being Upside-Down

Consumers who are “upside-down” in a vehicle are said to have “negative equity”—an oxymoron if ever there was one. Both terms simply mean the consumer owes more for a vehicle than it’s worth. Considering how quickly many vehicles depreciate, particularly if they are driven more than average distances (e.g. when commuting) and how often some consumers trade in; financing a car over 84-96 months commonly means consumers must take out a loan for a new vehicle that includes additional funds needed to pay off the negative equity owing on their trade-in.

Here’s an example:

Farah bought a car for $30,000 4 years ago.

She financed it for $366/month over 8 years (96 months) at 3.99%.

Farah drove her car 140,000 km over the last 4 years: now she wants to trade it in on a new car costing $35,000.

Because of her 8 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 now 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) and if the snowball effect of negative equity is considered it’s a borrowing technique that could eventually prove disastrous. (Imagine what might happen if Farah does the same thing four years down the road).

A Common Problem

According to many dealers more than 50 percent of customers with trade-ins have negative equity.

So before agreeing to an extended term loan for a vehicle purchase, consumers should educate themselves and consider how much they drive, how long they intend to keep the vehicle and how quickly it will depreciate. They need to be aware of the potential pitfalls of becoming a monthly payment junkie.

For more information about long-term auto financing and negative equity click here