If you still owe money on your car, there are a few steps you should take before trading it in. But be careful — negative equity can have a significant impact on your finances. It’s a workable situation, but it could mean paying a lot more money than you need to.

How does trading in a car work?

When you trade in your car, you sell it to a dealership. The dealership then applies the trade-in value of your old car to your new vehicle purchase.

When to pay off your car before trading it in

In almost every case, it’s best to pay down or pay off your auto loan before selling it or trading it in. The main concern is whether you have positive or negative equity on your loan. With negative equity, you will always want to pay off your auto loan before you trade in your car.

Positive equity

Positive equity on an auto loan means that you owe less on the car than it is worth. So, if you have $10,000 left on your loan, but your vehicle is worth $15,000, then you have $5,000 in positive equity. If you choose to trade in your car, the positive equity can go toward your next vehicle as a down payment, reducing the amount you need to borrow.

When you have positive equity on your loan, you don’t have to pay off your car loan in full before trading it in unless you want to. You will receive enough money from trading in to pay off the loan.

Negative equity

Negative equity is the opposite. If you still owe $10,000 on your loan, but your vehicle is only worth $8,000, you’ll have $2,000 in negative equity. This is what lenders and financial advice columnists call “being upside down.”

It’s a position you don’t want to be in. If you trade in your car with negative equity, you’ll have to pay off the remaining loan balance out of pocket before trading it in or roll the negative equity into your new loan. Rolling over negative equity into a new loan is not recommended because it can put you at risk of becoming upside down on the new loan.

How to trade in a car that is not paid off

People trade in and sell cars that have liens on them frequently. In fact, dealerships may advertise paying off your car for you when you upgrade to a new model. But selling a car you owe money on is more complex than just switching one vehicle for another.

  • Research your car’s value on sites like Edmunds and Kelley Blue Book. Look at vehicles with the same trim and compare average selling points in nearby areas.
  • Calculate your budget for your next car and how much you owe on your current one. If you owe more than you’re likely to get through trading it in, consider alternative options.
  • Gather maintenance records and other paperwork. This may help increase your car’s value as a trade-in by proving that it’s been taken care of.
  • Compare trade-in offers from dealerships — you don’t have to go to one place. Everyone may use the term “trade-in,” but really, you’re selling your car. You can negotiate selling price and shop around for different quotes to get the best deal.
  • Get everything in writing, especially if a dealership promises to pay off your loan. Be sure you have a copy of the offer. You’re still responsible for paying off your loan, so follow up and ensure your lender is paid after you trade in your car.

Alternatives to trading in a car

If you’re upside down on your loan, trading it in is unlikely to be the best course of action. Instead, consider selling your car to a private buyer, paying the loan down or refinancing it at a lower rate.

Working with a private buyer, rather than a dealership, may help you sell your car for more. However, you will need to handle paying off your lender and transferring the title yourself. This is something the dealership usually does on your behalf, so it may be an added hassle.

Paying down the loan may not be an option for most. But if your payments aren’t currently breaking the bank, set aside some extra money to break even. This way, trading your car in won’t involve rolling any remaining loan balance into your new auto loan.

Finally, try to refinance at a lower rate. Don’t extend your loan term in an attempt to lower your payment — this increases the chance that you’ll go upside down. Instead, reduce the total amount you have to pay.

Next steps

Provided you aren’t upside down on your loan, trading in your car for a less expensive option may be the right solution. If you do have negative equity, try refinancing instead — it may allow you to lower your interest rate so you pay less overall. Most importantly, don’t roll your remaining loan into a new one. Work with your lender, sell your car or find an alternative option to avoid taking on additional debt if you can help it.