Car finance: Negative equity explained

Negative equity normally relates to property – falls in house prices can leave owners in a position where they owe more on their mortgage than their home is currently worth.

But the rise in popularity of car finance packages has meant that negative equity is now a potential concern for many motorists as well.

Here we look at your options if you're in negative equity and how it relates to different types of car finance.

 

What is negative equity?

Being in negative equity means that the amount you owe to your car finance company is greater than the current value of that vehicle.

This situation isn’t as rare as you might think, especially when brand-new models are involved.

Depreciation in a car’s value is typically sharpest in the weeks and months immediately after it’s sold.

Let's say you're buying a car through a finance deal such as hire purchase (HP) or a lease. It wouldn’t be unusual for the car’s value to dip below the outstanding loan balance during this initial period.

What typically happens is that the rate of depreciation slows at a constant rate as you repay the debt, eventually leaving you in positive equity.

Negative equity and PCP

Some forms of finance – personal contract purchase (PCP) in particular – can make the negative equity calculation more complicated.

At the end of your PCP term, you usually face an optional one-off payment – known as a balloon payment – which you can make to buy the vehicle outright.

If, at the end of the PCP term, the vehicle is worth more than the balloon payment figure, there's positive equity available.

Here you have a choice:

• Make the balloon payment to buy the car
• Use the equity as a deposit on a new PCP deal

If the vehicle is worth less than the balloon payment – because it has depreciated to a greater extent than expected – you're in negative equity.

This means they don’t have any equity to carry over to a new PCP loan.

There’s still the option of making the balloon payment, but you can also choose to give the car back to the finance company.

Negative equity and HP

If you've bought a car with a hire purchase (HP) deal, you typically pay a monthly sum and at the end of a fixed period, you own the car.

Some HP deals also require a final payment to be made, but this is typically at a much lower level than on PCP.

Usually, the loan is paid off at a quicker rate than with PCP so this means there's less chance of falling into negative equity.

But if you do fall into negative equity, you should be able to cancel your current agreement and get a new loan on a cheaper vehicle. 

The negative equity trap

Perhaps the most serious issue that negative equity can create is if you need to sell your car during the loan term. For example, if you can no longer afford your monthly repayments, or you need to trade up to a bigger vehicle.

If you want to sell a financed car or part-exchange a car with outstanding finance, you need to pay back the full balance on the loan in order to do so.

But if the car is worth less than this balance, you have to make up any difference out of your own pocket.

Negative equity can also be a problem if your car is stolen or written off following an accident. This is because insurance companies usually only pay out the market value of a vehicle at the time of the claim.

If the loan balance at the time is higher than this value, you may be obliged to make up the difference.

You shouldn’t be adversely affected if you do face negative equity. This is provided that your car isn’t involved in such an incident and you’re able to continue your repayments until the end of the finance period.

One way to protect yourself from negative equity if your car is written off or stolen is to buy gap insurance alongside your financial agreement. 

Gap insurance covers the difference between the current market value of the car at the time of the accident and the amount of your original car finance deal. This means you don’t end up out of pocket and stuck paying off the remaining finance.

Voluntary termination of car finance

If you can no longer afford repayments on your car or no longer want it, it may be possible to hand it back to the finance company without additional costs. That's even if it’s in negative equity.

Under a rule known as 'voluntary termination of car finance', you're allowed to end your loan deal and return the car to the finance provider. This is only allowed as long as at least 50% of the total finance package – including any fees or additional charges – has been paid off.

For PCP customers, however, this total amount includes the final balloon payment – not just the monthly repayments.

Even if you haven’t reached 50% yet, you’re allowed to make a one-off payment to reach that level and then apply for voluntary termination.

Finance for negative equity

If you’re struggling to make repayments, it could be worth getting in touch with your finance provider. They might be able to restructure your loan – perhaps over a longer period – to make it more affordable.

This applies whether you’re in negative equity or not.

There are also companies that provide finance for car owners facing negative equity who wish to trade in their current model and switch to a new vehicle.

These are simply loans that combine the costs of clearing the negative equity with the price of the new car into a single monthly repayment over a fixed term.

How to avoid negative equity

The key factor that dictates whether you fall into negative equity is usually the rate of depreciation on the car. And it's impossible to know this in advance.

But the bigger a deposit you’re able to put on the car, the lower the loan amount – and the less chance of being hit by negative equity.

Depreciation tends to be steeper on brand-new cars, so sticking to used vehicles or older models may also help.

Negative equity: your options

What are your choices if your car finance deal has left you in negative equity?

• Do nothing: If you can still afford your monthly repayments and are happy with your car, there’s no need to act. The terms of your loan will remain the same until it’s cleared. If you’re on a PCP deal that's in negative equity at the end of the term, you can give the car back without making the final balloon payment.
• Sell or trade in your car: Sell your car and make up any difference between the sale price and the outstanding finance out of your own pocket.
• Trade in your car for a cheaper model and seek negative equity finance: This covers the gap between the outstanding loan and the trade-in price, as well as the cost of the new vehicle.
• Apply for voluntary termination: This is provided you’ve paid at least half of the total finance package and are prepared simply to hand the vehicle back.