Car finance: Negative equity explained
How does negative equity affect your car finance deal? Our guide explains everything you need to know.
Negative equity is a concept that 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 over recent years has meant that negative equity is now a potential concern for many motorists as well.
This issue can, for example, present difficulties for anyone who’s thinking about selling a financed car.
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What is negative equity?
For car finance customers, being in negative equity means that the amount they presently owe to the finance company for the vehicle 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.
So for anyone 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 while the loan is repaid at a constant rate, leaving the borrower eventually in positive equity.
Negative equity and PCP
Some forms of finance – PCP (personal contract purchase) in particular – can make the negative equity calculation more complicated.
Customers at the end of their PCP term generally face an optional one-off payment – known as a balloon payment – which can be made in order to purchase the vehicle outright.
If, at the end of the PCP term, the vehicle is worth more than the balloon payment figure, there is positive equity available.
Here the customer has a choice: they can either make the balloon payment to buy the car, or 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 – they’re in negative equity.
This means they don’t have any equity to roll over on to a new PCP loan.
There’s still the option of making the balloon payment, but the customer can also choose simply to walk away and hand the car back to the finance company.
Some HP deals also require a final payment to be made, but this is typically at a much lower level than on PCP.
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 which has outstanding finance on it, you’d 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’d 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: insurance companies will 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 again be obliged to make up the difference.
Provided, however, 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, you shouldn’t be adversely affected if you do face negative equity.
This is barring the fact that your vehicle could be worth less than you had hoped at the point the loan is paid off.
One way to protect yourself from negative equity if your car is written off or stolen is to take out 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 you originally took out finance for. 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 simply no longer want it, it may be possible to hand it back to the finance company without additional costs even if it’s in negative equity.
Under a rule known as “voluntary termination of car finance”, consumers are allowed to end their loan deal and return their car to the finance provider 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 on your vehicle, it could be worth getting in touch with your finance provider to see if they’d be willing 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 someone falls into negative equity or not is usually the rate of depreciation on the car in question – and this is impossible to know in advance.
However, the bigger a deposit or down payment you’re able to put on a purchase, 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 may also help.
Negative equity: your options
So to sum up, what are your choices if your car finance deal has left you in negative equity?
1. 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 which is in negative equity at the end of the term, you can simply hand the car back without making the final balloon payment or without moving on to a new PCP contract.
2. Sell or trade in your car and make up any difference between the sale price and the outstanding finance out of your own pocket.
3. Trade in your car for a cheaper model and seek negative equity finance – which covers the gap between the outstanding loan and the trade-in price, as well as the cost of the new vehicle.
4. Apply for voluntary termination, provided you’ve paid at least half of the total finance package and are prepared simply to hand the vehicle back.