Negative Equity in Car Finance – Everything you Need to Know
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 that depreciate quickly.
What is negative equity car finance?
When buying a car through car finance, it’s not unusual for borrowers to enter negative equity – when the car’s value is less than the finance payments due on it. This is because cars lose value as soon as you drive them off the forecourt.
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.
If you are in negative equity but want to sell your vehicle, you could face high costs. We’ll go on to explain how you can minimise the impact of negative equity in car finance in this article.
How negative equity impacts each type of car finance
Negative equity is to be expected in the first few months of taking out a car loan, but it does affect each type of car finance differently.
Let’s look at an 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. One month later, your vehicle could already have depreciated in value by £1,000, so it’s worth just £11,000.
Your finance, however, has only decreased by the £500. So you owe £11,500 on an asset that is now only worth £11,000 leaving you in negative equity by £500.
This isn’t a significant problem for most borrowers as the depreciation rate will slow down and your payments should eventually catch up. But negative equity can become a problem if you are in high negative equity later in a loan term, especially if you want to sell your vehicle and move to a different finance deal, or you cannot afford repayments.
Negative equity on personal contract purchase (PCP finance)
PCP finance agreements are different to other forms of finance, because to own the car at the end of the contract agreement borrowers have to pay a final sum - the ‘balloon payment’.
Because you make smaller repayments throughout the PCP loan term, you are likely to be in negative equity for longer than with hire purchase 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 retain more value 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 payment, they can return the car and use the surplus towards a deposit on a new car finance deal.
- Or, they could be in negative equity. In this case, the value of their car could be 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.
Selling a car in negative equity
Selling a financed car means you first need to pay off the full balance of the loan.
If the car's value is lower than the outstanding loan balance, you will need to pay more to clear this than you would receive from selling the car. This means selling the car wouldn't make a profit so you would have to pay for the difference in value yourself.
If you want to change to a new car finance deal while in negative equity, some lenders may agree to add the amount that you are in negative equity to the new loan. For instance, if you have £1000 in negative equity, £1000 could be added to a new car finance deal so repayments will cover this as well as the cost of your new car.
How does negative equity impact car insurance?
Negative equity can also affect the insurance claims you make on your vehicle. If you make a claim on your car insurance while in negative equity following a road accident in which your car was written off, or after the theft of your vehicle, you may be paid a lower sum than the value of your remaining payments to your finance company, leaving you out of pocket.
This is because insurers set the amount they pay out to policyholders based on the current market value of the vehicle. In the case that the insurance payout is less than the final payments of a finance deal, the borrower will have to make up the difference.
GAP insurance is an option for drivers that wish to protect themselves against their insurer paying out less than their car is worth due to negative equity. It covers the difference between the amount your insurer pays out should your car be written off from damage or if it is stolen, and what you initially paid for the car or have left to pay on your finance agreement.
For more information read our guide on GAP insurance.
How to minimise, avoid, or get out of negative equity car finance
It is worth remembering that negative equity isn’t necessarily a huge problem if you can continue to make your repayments for the full loan term and don’t want to sell or trade cars part-way through the agreement, as your vehicle’s depreciation rate will slow. It is difficult to totally avoid negative equity, because all cars depreciate in value.
There are a few ways to minimise the impact of negative equity on your finances, to ensure you don’t have to pay out a huge sum when you come to the point of wanting to sell or trade in your vehicle.
- Pay a larger deposit – by paying a higher deposit your repayments will be lower and your equity will be higher, because you own more of the car. The more you put forward as a deposit, the less likely you are to be in negative equity as your car depreciates.
The higher your deposit, the lower your monthly repayments will be, and paying a larger deposit will also reduce the interest rate you pay so you will pay less in total for your car.
- Overpay – by paying more than you owe each month, you build positive equity more quickly. Just ensure you are happy with any early repayment fees which may be charged.
- Research different forms of finance – you can protect your finances by researching and understanding which forms of finance are least likely to lead to negative equity.
- Complete the agreement – borrowers that like to swap their cars often are likely to be in negative equity if they become tempted to end their contract early, perhaps after only one or two years.
Because of being in negative equity they’ll have to pay a large sum in order to get out of their contract. If you don’t need to change your vehicle, it’s better to see out the term of your finance agreement to the end.
- Apply for voluntary termination – this rule allows you to return the car to the lender if you can’t afford repayments or you no longer want to drive it. As long as you have paid back 50% or more of the total amount repayable, including any fees, you can hand back the vehicle, even if you are in negative equity. For PCP contracts, 50% of the total costs includes the balloon payment. If you haven’t yet paid off 50% of your vehicle, you can make a one-time payment to reach the target and apply for voluntary termination.
John Ellmore is a director of NerdWallet UK and is a company spokesperson for consumer finance issues. John is committed to providing clear, accurate and transparent financial information. Read more