What is negative equity?
Negative equity occurs when the value of an asset is less than the amount owed on a loan to buy it.
Other terms used to describe negative equity include “underwater” and “upside down.” Below are contributing factors to negative equity:
- Long loan terms.
- Low down payments.
- Falling value in the market for the asset.
Though negative equity can occur with any asset, it is especially common with vehicles and homes, especially those purchased with loans that require minimal or no down payment.
A new car depreciates the moment you drive it off the dealer’s lot, putting the buyer at risk of having negative equity. One way to minimize negative equity is to opt for a shorter auto loan. This enables you to pay the balance down at a faster rate. You also can put down a larger down payment.
Negative equity example
If you purchase a home or auto with a small down payment, you are at risk of causing negative equity. This isn’t a problem unless you need to sell or trade in the asset.
For example, assume that you purchase a $20,000 car with with a car loan and no down payment. After you have owned the car for two years, it is worth $15,000 and you owe $18,000, creating negative equity of $3,000.
Due to a longer commute, you want to get a more fuel-efficient vehicle. You have to account for the $3,000 of negative equity to do so. Some dealerships permit borrowers to roll their negative equity into the new auto loan.
However, doing this ensures that you will be upside down on the new car loan from the beginning. It also increases your car payments, making your new vehicle more costly.
You also can pay the negative equity off with cash. If you cannot secure financing that resolves the negative equity or lack sufficient cash, you may be unable to purchase the new car.
Need to get in a new vehicle? See how negative equity will affect your auto loan.