Last updated:
January 2, 2024
Written by
Claire Fürst

Understanding and Managing Negative Equity in Car Finance

Negative equity happens when your car's worth dips below the amount that you still owe to the lender to settle your car finance agreement. This situation can be a bit of a headache if you're thinking about selling or trading in your car before your agreement has ended.

Every finance agreement will be for a specific car and the make, model, chassis (the part of the car frame which has the vehicle identification number) and registration number will be documented in the contract that you sign with the lender. 

This means that you cannot swap vehicles whilst in a finance agreement; you must take out a new agreement for each car that you buy using finance.

Let's look into the why's and how's of negative equity in car finance.

Factors Leading to Negative Equity in Car Finance

Car Depreciation

This is a key factor, especially when you first start your car finance agreement. In the first few years, the car tends to lose its value quickly, often dropping in value more rapidly than the amount you're repaying on the finance. If the car's value decreases faster than your repayments, there's a risk of ending up with negative equity.

Loan Terms

Choosing a loan with a longer repayment period (loan term) can slow down the growth of your equity in the car (equity is the difference between what your car is worth and the amount you still owe on it). 

A longer term means that more interest will be added to the principal amount you are borrowing. This delay in reducing the principal amount of the loan, combined with the car's faster depreciation in the first few years (loss in value), can lead to a situation where the amount you owe on the finance agreement is greater than the current value of the car.

To understand how interest rates work and can impact your loan total, check out our blog explaining the basics of APRs.

Initial Deposit

If you only pay a smaller deposit (also known as a down payment) at the start of your loan, it means you have a higher amount to pay off. As your car depreciates, this higher initial loan balance can more quickly result in negative equity, especially if the car's value decreases faster than the rate that you're paying off the loan.

Debt Rollover

Rolling over existing negative equity into a new car loan compounds the problem. It adds to the overall loan amount without addressing the loss in the vehicle's value, increasing the gap between what you owe and what the car is worth. Most lenders will have criteria in place to stop this happening too many times.

Overpaying and Modifying Your Car

Paying more than the market value for a car or making modifications that don't increase its value, can lead to negative equity. This is because these factors reduce the car's resale value, which can be much lower than the amount you owe on your loan.

Switching Cars Too Soon

Changing your vehicle before the loan term ends can cause negative equity, especially if you didn’t put down a reasonable sized deposit when you bought the car. At the beginning of a car finance agreement, your payments tend to pay off more of the interest due rather than the principal loan. If you switch cars too soon, the car might not have had enough time for its lowered value to match up with what you've already repaid. 

Payment Hiccups

Missing or making only partial payments on your car loan means the total loan amount left reduces slower than it should. As the car's value continues to depreciate, your loan balance remains comparatively higher for longer. Missed or late payments can also bring with them additional fees and added interest, which further increases the loan balance relative to the car's depreciating value.

Accidents and Insurance Gaps

Accidents leading to your vehicle being written off by your motor insurers can lead to negative equity, especially if this happens during the first half of your finance agreement. If your insurance payout, which is based on the market value of the car just before the accident, doesn't cover the remaining balance of your car loan, you'll be in a negative equity situation.

This occurs because insurance companies cover up to the car's depreciated value and do not take into consideration any loans outstanding against it. So, if the insurance payout falls short, you're left to cover the difference with your finance lender.

To find out about different GAP insurances available on Financed Cars, check out our overview here: Is GAP Insurance Right for Your Financed Car?

Different Car Finance Plans and Their Impact on Negative Equity

Hire Purchase (HP) and Conditional Sale (CS) Car Finance Agreements

How They Work

Both HP and CS involve an upfront deposit followed by fixed monthly payments. In HP, after your final payment, a small fee makes the car yours. In CS, the car automatically becomes yours after the last payment.

Equity Impact

  • Faster Equity Buildup: Your payments steadily reduce the loan balance, keeping pace with the car's depreciating value.

  • Lower Risk of Negative Equity: The consistent decrease in what you owe, aligned with the car's value over time, minimises the risk of ending up owing more than the car is worth.

Personal Contract Purchase (PCP) Car Finance Agreements

How It Works

PCP stands out with its lower monthly payments, followed by a large balloon payment at the end if you decide that you would like to own the car. This payment is based on the car's expected value at the end of the term.

Equity Impact

  • Deferred Ownership Cost: The lower payments during the term primarily cover the car's depreciation, not its total cost. This leads to a significant final balloon payment if you want to own the car.

  • Higher Risk of Negative Equity: Since you're not substantially reducing the car's total cost during the term, there's a higher chance of negative equity, particularly if the car's value at the end of the term is less than the balloon payment.

HP and CS: These options are like a gradual purchase plan. They are less risky in terms of negative equity due to the structure of the payments and the eventual ownership of the car.

PCP: Offers flexibility with lower monthly payments but comes with the warning of a significant final decision and payment. The risk of negative equity is higher with PCP, especially if the car's market value decreases more than anticipated by the end of the term.

Dealing with negative equity in car finance can be totally manageable with the right info and planning. Getting to grips with the different finance options, what causes negative equity, and the solutions at hand are the key to making wise financial choices.
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