The basic idea
Equity is the part of an asset you own outright: its value minus what you owe against it. With a car, positive equity means the car is worth more than the loan balance. Negative equity, sometimes called being upside down or underwater, means you owe more than the car is currently worth.
Suppose, hypothetically, you owe 16,000 and the car would sell for 13,500. Your negative equity is 16,000 minus 13,500, which is 2,500. If the car is worth 17,000 instead, you have positive equity of 1,000.
Negative equity is not a problem by itself while you keep the car and keep paying. It becomes a problem when you need to sell, trade in, or the car is stolen or written off.
How it happens
The loan balance falls slowly at first, because early payments are mostly interest. The car’s value, meanwhile, can fall quickly in the early years, as described when we look at how depreciation works. When the value drops faster than the balance, the gap opens. Common contributors include:
- A small or zero deposit, so you borrow close to the full price, or more
- A long loan term, which pays down principal slowly
- A high interest rate, which keeps more of each payment going to interest
- Rapid depreciation, from high mileage, damage, or a model that loses value quickly
- Fees and add-ons rolled into the loan, which raise the amount borrowed above the car’s price
- Negative equity carried from a previous car, added to the new loan
- Paying above the market value, so the car is worth less than the price from day one
The balance eventually falls below the value for most borrowers as payments continue, which is why the problem is typically biggest early in the loan. How long it takes varies a great deal.
Why it matters
When you sell
If you sell a car with negative equity, the sale price will not cover the loan. You would need to pay the difference to the lender so the lender releases its claim. Selling a car with a loan still outstanding involves extra steps, and the lender’s approval of the payoff is part of it.
When you trade in
A dealer can appear to solve the problem by adding the shortfall to your next loan. That is called rolling over negative equity. It makes the problem easy to ignore, but the new loan is then bigger than the new car’s price, and the new car starts out underwater by a larger amount. It is the most common way people get stuck in a cycle. Trade-in offers deserve a close look at the total amount being financed.
When the car is written off or stolen
Insurers generally pay the market value of the car, minus the deductible, not what you owe. If the loan is bigger, you must pay the difference yourself unless you have gap cover. That is why gap cover is often discussed for borrowers who put little down.
When your circumstances change
Negative equity limits flexibility. If you lose income, move abroad or need a different kind of vehicle, you cannot easily exit the loan without paying cash.
How to find out where you stand
- Ask your lender for the payoff amount, which is the total required to close the loan today. It may differ slightly from the statement balance because of accrued interest or fees.
- Estimate your car’s market value. Check listings for similar cars and use valuation tools, keeping in mind how buyers estimate a used car’s value. Trade-in values are usually lower than private sale values.
- Subtract the value from the payoff amount. If the result is positive, that is your negative equity.
Options for handling it
None of these is right for everyone, and each has costs.
- Keep the car and keep paying. Often the simplest option. Over time the balance falls and the gap shrinks, as long as the car is still reliable.
- Pay extra toward the principal. Even modest extra payments reduce the balance faster. Confirm that extra payments go to principal and that there are no early repayment fees.
- Pay the gap in cash when you sell. This ends the loan but requires savings.
- Refinance carefully. A lower rate might help, but extending the term could increase the total interest and keep you underwater longer. Compare the total repayable.
- Use a personal loan to cover the gap when selling. This replaces one debt with another, so compare costs honestly.
- Roll it into the next loan. This is possible but risky, because it increases the amount borrowed and makes the next car harder to exit. Treat it as a last resort.
- Wait. If you do not need to sell, waiting is often the cheapest choice.
How to avoid it in the first place
- Put down as large a deposit as is sensible
- Choose a shorter term if the payment is manageable, as explained in the guide to loan terms
- Avoid rolling add-ons and fees into the loan unless you are sure of their value
- Consider a used car that has already taken its steepest depreciation, when it fits your needs
- Negotiate the price before talking about financing
- Keep the car in good condition, since it supports its value
- Consider gap cover when you borrow most of the price, comparing prices and terms carefully
If you are already in negative equity, talk to your lender about your options, and consider impartial financial advice if the payments are difficult. Rules and protections vary by country and state, so check local guidance. The key is to understand the numbers and avoid decisions that make the gap larger.