When you owe more on your car than it's worth and want to get rid of it for a new one, the car industry refers to it as being upside down. In that situation, you might still be able to get a new lease or a new loan and roll that "negative equity" into the new car. Doing it could be expensive, though.
Being Upside Down
Car dealers typically pay less for cars than they sell them for -- that's how they make their money. Furthermore, the value of a new car usually drops significantly once you buy it since your purchase turns it into a used car. For instance, if you buy a new car for $20,000 and it loses 20 percent of its value, it would be worth only $16,000. As another example, when you buy a used car for $10,000, the dealer might only buy it back from you for $8,000. If you don't put enough down on the car to make your loan balance less than what it is worth after the loss, you'll be upside down. For instance, a $2,500 down payment on the $20,000 car would leave you owing $17,500 and being $1,500 upside down if you had to sell it for $16,000.
Financing Negative Equity
If you have negative equity, the car dealer might offer to build it into your new loan or lease. However, if you do this, you'll also owe more money on your new car. If you don't make a down payment, you could also end up being even more upside down on the new car, which will make it harder to trade it in and replace it when you're ready for a new car.
How Leases Work
When you lease a car, you technically rent it rather than buying it, and you pay for only the portion of the car that you use. If you use up 50 percent of a car's value during the lease period, your lease payments essentially get calculated on 50 percent of a car's price. For instance, if you're thinking about leasing a $20,000 car and it will have a 60 percent residual value -- its worth after your lease -- it means that you will have used up $8,000 worth of the car. The amount you use up -- called depreciation -- gets divided by the length of the lease and, along with the interest and taxes, is turned into your monthly payment.
Leases, Loans and Negative Equity
When you put negative equity into a lease, it's especially expensive. If you buy a $20,000 car and you include $3,000 in negative equity in the price, you end up financing $23,000, which is a 15 percent increase. With a lease, you're paying for only a portion of the car's value. For example, for the same $20,000 car with a lease residual of $12,000, you have to pay for $8,000 in depreciation. Adding in $3,000 in negative equity leaves you paying for $11,000, a 37.5 percent increase in what you're paying for.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.