Negative equity and car finance: What is it and when can it be a problem?
If you’re in negative equity on your car finance it means you owe more in repayments to your provider than the current value of the car you’re driving. Negative equity occurs quite often with new cars because they depreciate quickly.
You might have come across negative equity in the context of mortgages, but it is also something you need to be aware of with car finance.
Being in negative equity during your car finance agreement isn’t necessarily a problem if you continue making the payments and keep your vehicle. However, issues can arise if you want to end your contract early or you write off your car.
Find out more about negative equity and what it could mean for you and your car finance.
What is negative equity in car finance?
You are in negative equity if the amount you owe on your car finance agreement is more than the current value of the vehicle.
For example, let’s say you bought a new car on a finance deal for £12,000, and you’ve paid one monthly payment of £500. Meanwhile, the following month, your vehicle has depreciated in value by £1,000, so it’s now worth just £11,000.
Your finance, however, has only decreased by £500, so in this case, you owe £11,500 on an asset that is now only worth £11,000, leaving you in negative equity by £500.
When buying a car through car finance, it’s not unusual for borrowers to enter negative equity. This is because cars lose value as soon as you drive them off the forecourt, with the AA calculating that new cars could lose up to 40% of their value within one year.
New cars depreciate most steeply in the first few weeks after a sale. However, after this point, the rate of depreciation flattens out, meaning that with each repayment made, the borrower is closer to reaching positive equity.
Negative equity won’t be a significant problem for most borrowers as the depreciation rate will slow down and your payments should eventually catch up by the end of the contract. But, it can become a problem if you are in negative equity later in a loan term, especially if you want to sell your vehicle, move to a different finance deal, or write off your car.
PCP and negative equity
Personal contract purchase (PCP) finance agreements are different from other forms of finance because, to own the car at the end of the contract, borrowers have to pay a final sum known as the ‘balloon payment’.
This balloon payment is based on how much the dealer thinks the vehicle will be worth at the end of the contract, so they try to estimate how much the car will depreciate. Your payments will then cover the difference between this figure and the cost of the car at the time of purchase.
Because you don’t cover the full cost of the car with your monthly payments on PCP, you make smaller repayments. This means you don’t repay the debt as quickly and so you are more likely to be in negative equity for longer than if you took out a hire purchase agreement for example, which has larger monthly payments.
By the end of the PCP contract, all being well, you should no longer be in negative equity and the car will be of a similar value to the balloon payment, if not more.
There are several possibilities when a borrower reaches the end of their PCP contract.
- They will be in positive equity – their vehicle will be worth more than the balloon payment, so they could make the payment and either keep the car or sell it for a profit.
- They are in positive equity but, rather than making the balloon payment, they can part-exchange their car to settle their finance and use the surplus towards a deposit on a new car finance deal.
- Or, they could be in negative equity, so the value of their car is less than the balloon payment. In this situation they can cut their losses and return the car; the negative equity would then be the lender’s problem.
- Of course, even if you’re in negative equity you could still pay the balloon payment to own the car. However, this means you would have paid more for the car than it’s actually worth, so it will unlikely make the most financial sense.
When can negative equity be a problem?
In most cases, being in negative equity won’t be a significant problem. However, it can be an issue if:
You want to sell your car on finance
To sell your car on finance, you need to get a settlement figure from your finance provider and pay this off to become the vehicle’s legal owner. If you are in negative equity, the settlement figure will be more than your car is currently worth. This means selling the car would be unlikely to make you a profit, so you would have to pay the difference in value out of your own pocket.
You want to trade in your car for a new model
Part way through your contract or at the end of a PCP agreement, you may want to exchange your car. If you are in positive equity, you may be able to use this equity towards a deposit for a new finance agreement. If, however, you’re in negative equity, you would need to pay the deposit out of your own money or, as explained below, you could take out specialist negative equity finance if the provider offers this.
You write-off your financed car or it gets stolen
If you have a car on finance or you lease a car, and the vehicle is written-off, you still need to pay your outstanding finance. Your car insurance payout will cover the market value of your car at the time of the incident, but if you’re in negative equity, this won’t be enough to clear your finance.
This is where a GAP insurance policy can help as it can make up the difference between your car insurance payout and the finance you have left to pay on your contract.
For example, you might have £8,000 left to pay on your finance, but your car insurer may only pay out £6,500 as that was how much your car was worth when it was written off. GAP insurance would pay the remaining £1,500 so you don’t have to pay this lump sum yourself.
What can you do if you’re in negative equity?
If you find yourself in negative equity, you have several options including:
Continue making your monthly payments
As long as you can afford the payments and you don’t want to change your car, your payments should have caught up with the depreciation of your vehicle by the end of the finance contract, so you should no longer be in negative equity.
Because there’s no balloon payment to pay at the end of an HP contract, negative equity won’t be of much concern, unlike with PCP. If you are still in negative equity at the end of your PCP contract, you can choose to return the car and cut your losses instead of making the balloon payment.
Cancel your agreement through voluntary termination
As long as you have repaid 50% or more of your total finance agreement, you can return your car to the lender at no extra cost through voluntary termination. You can do this whether you are in negative equity or not. Voluntary termination is designed to help people who are struggling to make their monthly finance payments.
Take out specialist negative equity car finance
If you were hoping to exchange your car on finance and use any equity as a deposit towards your next deal, finding yourself in negative equity can be a problem. To help those who may not have enough cash to put down a deposit for a new deal, some providers will offer specialist negative equity car finance.
This means the negative equity would be carried over to your new agreement. For example, if you had £500 of negative equity on your current finance agreement, and your new finance agreement was for £10,000, you would end up borrowing £10,500 overall.
However, bear in mind that this means you would borrow more and pay more in interest. You also increase the risk of getting into a cycle of negative equity. If your car is worth £10,000 but your finance agreement is for £10,500, you would be in negative equity before you even drive off in your car so it will be harder and take longer for your payments to catch up.
How to minimise the problem of negative equity
It is worth remembering that negative equity isn’t necessarily a huge problem if you continue to make your repayments for the full loan term and don’t write off your car or want to end your agreement early, as your vehicle’s depreciation rate will slow. It is difficult to totally avoid negative equity, because all cars depreciate in value.
However, there are a few ways to minimise the impact of negative equity
Buy a used car
Used cars can depreciate less quickly than a brand-new car.
Pay a larger deposit
By paying a higher deposit, you own more of the car early on in the contract so you will have more equity in the car. You will need to take out less finance overall, so you minimise your chances of owing significantly more than the value of your car.
Make larger payments
If you can afford to, making larger payments will clear your debt more quickly and help you to get into positive equity more quickly. You could also consider making overpayments, but make sure you are aware of any early repayment fees the lender may charge.
Keep the car in good condition and don’t go over any mileage limits
Cars in good condition with a low mileage won’t lose as much value as a car with lots of wear and tear and a high mileage. Sticking to any mileage restrictions set out in your agreement is particularly key for PCP, as the mileage you say you will drive helps the provider to estimate how much your car will depreciate. If you drive more than agreed, the car may depreciate faster than estimated and so you may be more likely to end up in negative equity. The provider may also charge you extra fees.
Take out GAP insurance
Being in negative equity can be a significant problem if your car is written off and you don’t have the money to pay off your finance agreement. Especially if you write off your car towards the beginning of your agreement, there is likely to be a shortfall between the amount you owe on your finance and the amount your car insurer will pay out. GAP insurance will cover this deficit.
If you could afford to make up this shortfall yourself, you may not feel like GAP insurance is worth getting. However, having GAP insurance could give you peace of mind should something happen to your car and you’re left with a large payment to cover. Before taking out a policy, make sure you research and compare your different options to find the one that is most suitable for you.
» COMPARE: GAP insurance policies
Rhiannon is a financial writer for NerdWallet, with a particular interest in personal finance and insurance guides for consumers. Read more