While there's likely no one left who doesn't understand the concept of an upside-down mortgage, the upside-down car loan gets much less press. Entering into a new car loan with negative equity is never a good idea, as owing more on a car than it's worth can be the beginning of a serious financial downward spiral.
Negative Auto Equity Explained
Upside-down mortgages were so difficult for many to grasp because of the old adage that homes never lose value, but increase or stay static in value as years pass. That has never been the case, however, with cars. As soon as you drive a new car off the dealer's lot, your car depreciates in value, often losing several thousand dollars off the original sticker price. If you financed the entire purchase price, you're already experienced the phenomenon of negative equity, which simply means you owe more than the car is worth.
Negative Equity and Trade-Ins
When buying a new car, you may decide to trade in your old car. If you owe more on your old car than it's worth, the new car dealer will add the amount of negative equity to the loan for the new car. So if, for example, the new car costs $25,000 and you owed $4000 more on your trade-in than it was worth, you will be borrowing $29,000 on a car that was worth only $25,000 new. Once the car depreciates, you're even more underwater.
Negative Equity and Length of Loan Term
The most obvious effect of negative equity on a car loan is that it nearly always extends the term of the car loan to long past the traditional 36-month term for car loans. In order to keep payments down, car dealers and lenders will extend the term of the loan to 48 or even 96 months, leaving consumers with a car payment far into the life of the car, or, sometimes, long after the car has already been scrapped. This means that you may still be underwater when it comes time to trade in the new car, repeating the cycle.
Negative Equity and Car Costs
A longer loan term may mean lower payments, but it also means paying more interest over time, adding even more expense to an already expensive proposition. Additionally, because the lender isn't completely covered in the event something goes wrong with the loan, you may have to pay a higher interest rate to compensate for the greater risk. Should the car break down, receive significant damage in an accident, or just no longer suit the buyer's needs, the buyer is almost always stuck with a car payment for a car he or she can no longer use, despite the need for a new one. Unless the buyer can afford to pay off this debt and buy or finance a new car, the negative equity spiral continues downward.
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