Negative equity explained

Equity is the difference between what you owe on a loan on an asset and what the asset is worth - the amount you could recoup if you sold the asset. Negative equity is a scenario in which you owe more to a lender or finance company than the asset is worth.

Negative equity is a common problem for homeowners during economic downturns when the value of their property can dip below the outstanding balance on their mortgage. But as car finance has become more popular, it’s affected motorists too.

Cars are depreciating assets. Except for some classic cars, your vehicle will never be worth as much as it was on the day you bought it. For new vehicles, the loss of value is particularly steep in the first few weeks and months after they’re driven off the lot. And when you add the interest and fees of the loan, it’s easy to see how you could end up owing more to your car finance provider than the vehicle is worth.

For instance, you may have taken out a £10,000 loan on a vehicle. After a few months of payments, the balance is £9,000, but you discover the car is only worth £8,000. You’re therefore £1,000 in negative equity on your vehicle.

Negative equity on car loans is common in the first weeks and months of owning a vehicle. Your car is quickly eroding in value simply because it’s no longer new and you haven’t made enough payments to bring down the balance on the loan.

But it can become a problem if you’re in significant negative equity later in the loan term. Specifically, it can be an issue if you want to sell the vehicle - for example if you want to upgrade to a new, perhaps larger car or because you can no longer afford to make the loan repayments.

If you want to sell a financed car, you’ll need to pay off the full balance of the loan. But if the value of the vehicle has fallen below the loan balance, you’ll need to make up the difference out of your own pocket. This may mean you need to come up with thousands of pounds just to even sell a vehicle.

A similar situation applies if you want to part-exchange a vehicle with outstanding finance on it. In these scenarios, you may end up unable to afford to ditch your current car and its loan.

Negative equity can also be a problem if your vehicle is stolen or written off following an accident, and you make a claim on your car insurance. Insurers base the amount they pay out in claims on the market value of the vehicle. You therefore may receive a lower sum for a stolen or written off car than you owe to the finance company and may be required to pay the finance provider the difference.

However, if you’re satisfied with the vehicle, able to afford its loan repayments, and aren’t struck with misfortune that requires you to make a substantial insurance claim, being in negative equity won’t adversely affect you.

It’s difficult to avoid negative equity on car finance entirely because you are taking out a loan against a depreciating asset. But there are a few ways you can minimise your negative equity position and ensure you don’t have to pay thousands of pounds out of your own pocket when it comes to selling or trading in the vehicle.

• Put down more money upfront: Having a more substantial deposit means you’ll have more equity in the car at the outset. As the value of your vehicle naturally depreciates, you might not end up in negative equity at all - or at least not much. Furthermore, the more money you put down upfront, the less you’ll owe in monthly payments. Borrowing less money also means you’ll pay less in interest, so your total costs will be lower.
• Take out a loan with a shorter term: You’ll face higher monthly payments, but you’ll be paying off more of the car each month. This increases your equity and limits the amount of time you spend in a negative position.
• Make overpayments: Paying more each month than you owe will also allow you to build up equity in the vehicle more quickly.
• Use hire purchase rather than personal contract purchase: With hire purchase (HP) car finance deals, you make larger monthly payments and own the car at the end of the term. With HP, you’ll build up equity in the car faster and can climb out of negative equity more quickly. With personal contract purchase (PCP) car finance deals, you’ll make smaller payments but won’t own the car outright at the end. You’ll either face a large balloon payment to buy it or will need to give it up. You’ll typically be in negative equity throughout much of the term of these car finance deals.
• Don’t swap cars often: Already bored of the vehicle you’ve been driving for a year? You’re likely still in negative equity with the loan and will need to make a substantial upfront payment to sell or exchange it. Unless you have a compelling reason to upgrade - an addition to your family that means you need a larger vehicle, for instance - you should try to avoid swapping within the first couple years after purchasing a new car.