One of the problems car buyers often get caught out by with regard to their car finance is negative equity, and it can get them into financial trouble. But what is negative equity and why is it a problem?
In this article, we will look at the following:
- What is negative equity?
- Why is negative equity a problem?
- Why carrying over negative equity is a bad idea
- How to minimise your negative equity
What exactly is negative equity?
Equity is the difference between what you owe to the finance company for your car loan and what the car is actually worth. If your car is worth more than you owe the finance company, the difference between the two is called positive equity (and usually just referred to as equity). It means that if you sell or part-exchange your car, you can pay off your finance and still have something left over. Yay!
Current car finance settlement: £10,000
Current car value: £12,000
If your car’s value is less than what you still owe on it, that difference is called negative equity. That means that if you sell or part-exchange the car, the money you get for it won’t be enough to pay off your finance and you will have to pay the difference from your savings. Not so good.
Current car finance settlement: £16,000
Current car value: £12,000
Negative equity: £4,000
This is caused by the car losing value (depreciating) faster than you are repaying the loan. It will always happen at the start of your agreement and that’s perfectly normal, but it becomes a problem if there is still a significant negative equity difference later in the agreement, at the time when you are thinking about selling or changing your car.
Having significant negative equity is very likely if your finance agreement is a PCP (personal contract purchase), especially if you have a small deposit and/or are taking the finance agreement over a long period (four or more years). Given that this exact scenario applies to millions of car owners in the UK, it’s fair to say that there are a lot of people who could potentially be in serious trouble if their financial circumstances change.
Why is negative equity a problem?
If your financial situation changes (eg – you lose your job, you have unexpected divorce or hospital expenses, etc.), you may be in a position where you can’t afford to keep up your monthly car payments. If your car finance is in negative equity, then even if you sell the car you still haven’t got enough money to pay off the debt to the finance company.
The example shown earlier had £4,000 of negative equity. If you were able to sell that car (and you’re probably not allowed to anyway), that means you would need to find £4,000 on top of what the buyer has paid you in order to clear the finance still owing on the vehicle. And the majority of car owners won’t have that £4,000 available to settle the debt.
If you default on your debt to the finance company, they will charge you late fees on top of the payments you already can’t pay. So your debt goes up, making your situation worse. When you still can’t pay, the finance company will call in a collections agency and that will take your problems to a new level. In addition, your default on the loan will be recorded on your credit history, making it harder to borrow money in the future or try to manage your way out of the problem. It’s a downward spiral that can easily end up in bankruptcy.
This scenario is very common in car finance. If you have a hire purchase, you will usually have negative equity until you are about two-thirds of the way through your agreement (depending on how much deposit you paid up-front).
If you have a PCP agreement, you may end up being in negative equity all the way through to the end of the agreement and have to rely on giving the car back to claim your GFV (guaranteed future value) to cover your negative equity.
Carrying your negative equity over simply increases your risk
If you want or need to end your agreement early and change your car, you will almost certainly have negative equity to deal with – particularly if you have a PCP.
What people are often inclined to do is add their negative equity debt onto their new finance agreement. Some finance companies will simply not allow this, and in the aftermath of the financial crash of 2008 there was a bit of a crackdown with finance companies refusing to allow buyers to transfer negative equity from their old car to their new one.
However, it seems that this practice is on the rise once again. Steady growth in enquiries about carrying over negative equity here at The Car Expert suggests that it is becoming increasingly common once again, and that more finance companies are now allowing it. This is concerning.
What usually happens in this scenario is that the salesperson at the dealership breaks the bad news that your part-exchange is worth less than you thought, and that it’s not enough to cover the balance still owing on your finance: “But you don’t have to worry! We can just carry that amount over onto your new finance agreement, and all that will happen is that you’ll pay a few pounds more per month to cover it. It’s easy.”
At this point, the salesman will sit back, offer his best reassuring smile and insist that’s it’s no problem whatsoever.
Except that’s not really true…
Let’s go back to the example at the top of the page: You have £4,000 of negative equity in your current finance agreement, and now you want to borrow an extra £4,000 on your new agreement to pay that off. What the dealer will almost always fail to mention is that you have already paid interest on that £4,000, and you are now going to pay more interest on the same money because you are borrowing extra to cover it. But that’s only a minor problem.
The major issue is that you will be paying an extra £4,000 over and above the price of your new car.
Let’s say your new car costs £30,000. Your new finance agreement will include interest and fees, so your total amount repayable will probably end up being about £34,000. That’s already a negative equity of £4,000 before you have even started.
That new car will depreciate just as quickly as your old one, but the extra £4,000 of debt that you have whacked on top of the price means you are basically paying £38,000 for a £30,000 car. So if you run into any financial problems over the next three or four years, you have multiplied your problems because you have vastly increased your negative equity.