How to Trade in a Car With Negative Equity: What You Need to Know

Before you roll debt into your next loan, here’s what lenders, carry, and credit really mean.

In How to Trade In Your Car, I talked about a young couple who traded in their old car for something newer and bigger. In that scenario, their car was paid off, so it wasn’t a problem. The value of the trade-in was simply deducted from the price of the new car, lowering the total price they paid.

But what happens when you trade in a car that you still owe money on? That’s when you may get to meet the two biggest villains in car sales: negative equity and poor credit.

Side Note: "Equity" is kind of a misnomer when it comes to automobiles, because unlike real estate, which tends to hold its value or even increase over time, automobiles are depreciating assets. So you never have true equity in an automobile (unless it’s a classic, in which case its value may increase). But equity is the term used in car sales, so that’s the term we’ll use.

You have equity when you own your car outright, and there are no liens against it. Negative equity, which is far more common, is when you owe more on your car than it’s worth. How does this play out in an actual sale?

Best-Case Scenario: A Small Negative Equity Hit

Let’s look at a best-case scenario first. Imagine you’ve paid down your car loan for a few years and have only one year left to go. When you trade in your car, you find out that you owe a bit more than it’s worth, but not too much, say $2,000. You can either put down $2,000 to cover your negative equity, or you can roll that $2,000 into the financing of the new car. If you choose the latter, which is not recommended, your payment goes up approximately $40 a month. Not ideal, but not a deal-breaker, either.

Before I describe a worst-case scenario, let me introduce a concept most people outside of the car business are unfamiliar with, called the “carry.”

The Hidden Rule Most Buyers Don’t Know: The Carry

A lender knows everyone who buys a car through a dealer has to pay taxes and fees. If you’re buying a car with a sale price of $30,000, you’re going to pay approximately $3,000 more in taxes and fees, or $33,000 total. If you have average credit, the lender is willing to finance that amount, which is 110 percent of the selling price. In some cases, they may even be willing to finance more than that, maybe 115 or 120 percent. That additional percentage is called the carry.

Going back to our scenario above, where you owe $2,000 on your trade, your total would be around $35,000 if you don’t put any money down. That means the carry would go up to around 116.7 percent. Now, if you have really good credit, the lender may go ahead and approve that. If you don’t, you may have to plunk down a few bucks to get it to 110 percent.

When You’re Deep Upside Down

But what if you owe $26,000 on a car that’s worth only 20 grand? In that case, you’re said to be “upside down” or “buried” by six grand. In that case, the carry needs to be about 130 percent to cover that six grand. So you’re either going to have to have stellar credit, or you’ll need to put down a substantial amount of money.

When does the carry become critical? Suppose you have an expensive luxury car, and you want to trade down to something cheaper to lower your payment. You’ve been looking at cars in the 10 to 12 thousand range because you know that will give you a payment under $250 a month. But you also know you’re probably about 10 thousand upside down. How does that work?

It doesn’t. You can’t trade in a car you owe 10 grand on for a car that’s worth roughly that same amount. That would be a 200 percent carry, which is something no bank will approve. To make that scenario work, you’d need to be looking at a $20,000 car, at a minimum.

Time to tag-team poor credit into our scenario. When poor credit enters the ring, it changes the amount the lender is willing to carry. Instead of 110 or 115 percent, they may be willing to finance only 80 percent of the money you need. If you’re trying to buy a $33,000 car, they may only approve you for 80 percent of that, or $26,400. Which means you’ll need to come up with $6,600 out of your own pocket. That’s called having skin in the game. The lender has greater confidence that you’ll pay them back if they know you’ve invested heavily in the loan.

But a lot of people don’t have $6,600 to put down. That right there—the combination of poor credit, negative equity, and limited carry—kills a lot of car deals. Approximately 30 percent of the cars on the road today are carrying negative equity. And not just a small amount. Some studies indicate it’s as high as $7,200 per car.

How Buyers Dig Themselves Into a Hole

How did things get this messed up? There are two reasons. The first is, the average cost of a new automobile in the U.S. has risen to roughly $50,000 in the last few years. The higher the price of the car, the easier it is to get into a negative equity situation.

But the real reason is, people simply don’t know how to properly buy a car. First, they put nothing down, or as little as possible. Second, they focus on getting the lowest payment they can instead of putting themselves in an equity position as soon as possible. And third, to get to that low payment, they go for the longest term available: six, seven, even eight years. This is digging a very deep hole for yourself.

Here’s the way I look at negative equity. Imagine taking your old car, cutting off a big chunk of it—maybe the trunk and the rear wheels—then hitching that up to your new car and dragging it around behind you for the next five years. It makes absolutely no sense. Yet thousands of people do it every day.

The smart way to buy is to lease, in my opinion. But if you must finance, put at least 20 to 25 percent down, focus on getting yourself into a position of equity as soon as possible, finance for the shortest term you can tolerate, maybe three to four years, and choose a car that’s within your budget and is known to hold its value.

In other words, take the emotion out of it. Buy with your head, not your heart.