Trading in your current car while it still has an outstanding loan against it is the norm more than the exception, but it presents some special considerations. The lender has a stake in the car because it acts as collateral for the current car loan – the lender can legally repossess the vehicle and sell it if you default on payments. You’re contractually obligated to repay the remaining balance, and sometimes your car might have depreciated to the point where the value of your car is no longer worth the amount of your outstanding loan balance. This presents another wrinkle in the form of negative equity.
None of this means that you have to find a way to pay the loan amount off before you trade in a car, however.
How a Trade-In Works
Your car is a tangible asset with monetary value, with or without a loan against it. You’re effectively giving that value to the dealership when you trade it in on a new vehicle, in lieu of or in addition to making a cash down payment on your new purchase.
The dealership becomes the new owner of the vehicle after the trade-in, so they can sell it to someone else to reclaim that cash. The trade-in value of the car acts as a down payment on your new car purchase.
Read More: Can You Trade in a Car If It Is Not Running?
What Happens to the Loan?
Of course, the loan still exists regardless of who has technical “ownership” of the traded-in vehicle. The obligation doesn’t just go away because you don't have the vehicle any longer. You're still contractually on the hook until the loan is paid off. The dealer has to make sure it’s paid off, too, so it can resell the car. This is typically accomplished by rolling over your initial loan balance into another loan taken on by you to purchase your new vehicle.
For example, you might still owe a $3,000 balance on your existing car loan, and the car is worth $3,000. You want to purchase a $25,000 car. The dealer will give you a $3,000 credit on the purchase price for the value of your old car that it's now taking ownership of. You’re actually paying just $22,000 for those new wheels as a result. But you’ll still have to take out a new loan in the amount of $25,000 to pay off the first loan in addition to financing the $22,000 for the new vehicle, assuming you don't also put any cash down.
The dealer might pay off that $3,000 for you to facilitate the deal, but you’d still have to borrow $25,000 so you can repay that money to the dealer. Otherwise, it would be giving you $6,000 for that trade-in: $3,000 toward the new car's purchase price plus $3,000 out of pocket to vacate your first loan and that lender's legal interest in the car.
Of course, all this assumes that you have positive equity in the vehicle. Maybe you still owe $3,000 on a car that’s only worth $2,500, resulting in negative equity instead. This more commonly happens with newer trade-ins – cars that are only a couple of years old – but the bottom line is the same. You’ll still have to borrow $25,000 to cover that additional $500 because the existing loan still has to be paid off.
Read More: How to Trade in a Car With Negative Equity
Disadvantages to Consider
The process of trading in your collateral car for a nice, new one is easy enough, but it’s not without pitfalls. You’ll almost certainly end up with negative equity in your new vehicle – you’ve borrowed $25,000 for a $25,000 car in this scenario, and that $25,000 value is going to reduce rather radically as soon as you drive it off the lot due to depreciation. The general rule of thumb is that a car loses about 20 percent of its value immediately upon sale. Now you owe $25,000 on a $20,000 car because 20 percent of $25,000 works out to $5,000.
You’ll also want to check your loan contract on your trade-in before you commit because some lenders impose prepayment penalties if you pay off the loan early, before the end of the contract term, and these penalties can sometimes be significant. This could mean more money that you’d have to roll into the new loan to cover them, increasing that depreciation gap and creating negative equity before you even get your car home.
Do Some Groundwork First
You can increase your odds of a positive outcome if you do a little research before approaching a dealership with the idea of trading in your old car for a new one. It’s critical that you have a pretty firm idea of what your existing car is honestly worth. There are numerous sites online that can help you come very close to pinpointing its value, such as Edmunds, Kelley Blue Book and the National Automobile Dealers Association. You won’t want to settle for a $2,500 trade-in value if your car is genuinely worth $3,000. That's a $500 difference that you’re not going to have anything to show for.
Take some time to gather your necessary documents in advance as well. You should have your loan contract in hand and your most recent statement, if not a printout of all the payments you’ve made to date. You’ll want proof of your existing car's current registration and up-to-date insurance coverage as well, and it wouldn’t hurt to print out your research regarding the value of your trade, either – the more quotes you have, the better. And it goes without saying that you’ll want your existing car to be squeaky clean and in the best condition possible and to be able to provide records of diligent maintenance as well.
Try to avoid the temptation to trade in your Toyota Camry at your local Jeep dealership simply because there’s a new Jeep model available this year that you really, really want to own and drive. A Toyota dealer won’t be as deterred by any issues your used Camry might have because its service department is well-acquainted with repairing the make and model of your vehicle. And that Toyota dealer more or less has a built-in audience for potential trade-in buyers of your car, so it might be more willing to accept your car as a trade-in and give you a fair price.
You might also want to take a copy of the proposed sales contract to a financial expert for review before signing it, particularly if you have negative equity in your trade-in. Have an expert explain in plain, understandable terms how the dealership is going to treat the situation and how this will impact your future finances.
When the Deal Is Done
You’re not quite finished yet when you drive your new vehicle into the now-empty space in your garage. Don’t neglect to contact your old lender to make absolutely sure that the loan has been paid off as part of the transaction. The bottom line is that it’s your credit, not the dealership’s, that’s at stake here if that loan wasn’t actually paid off for some reason. Get it in writing that the loan has been satisfied.
Read More: When Does an Auto Loan Go into Default?
- Car and Driver: Trading in a Car With a Loan – Everything You Need to Know
- Federal Trade Commission: Auto Trade-Ins and Negative Equity
- Autotrader: How Do You Trade in a Car You Haven’t Paid Off?
- Auffenberg Dealer Group: Can You Trade in a Financed Car?
- Atlantic Financial Federal Credit Union: How to Trade in a Car with Negative Equity – Your Options
- Capital One: Trade-In Tips – What You Should Know Before Trading in Your Car
- Debt.org: What Is an Upside Down Car Loan?
- Carfax. "Depreciation." Accessed Feb. 10, 2020.
- Federal Trade Commission. “Auto Trade-Ins and Negative Equity.” Accessed Feb. 10, 2020.
- FTC. “Financing a Car? Ask About Pre-Payment Penalties.” Accessed Feb. 10, 2020.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.