What Is Negative Equity?
Negative equity occurs when the value of your car is lower than the amount you currently owe on it. It doesn’t need to be hugely concerning, but it could cause some minor problems down the road.
Traditionally, negative equity has been a problem for house buyers. But as we move more towards the financing of cars as opposed to buying them outright – it is becoming more common among car buyers too.
Are you considering taking out a car finance agreement, but want to know more about negative equity before you sign? Read our guide to find out everything you need to know about what it is, how you can avoid it and our expert tips on dealing with negative equity on your car finance deal.
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What is negative equity?
Negative equity is essentially when the total borrowing secured against something (in this case a car) is greater than its value. This is not uncommon among new vehicles as depreciation causes the value to drop significantly during the early stages of driving it. However, as depreciation slows down, your monthly repayments close the gap and more often than not you’ll end up with positive equity by the time your contract finishes.
For example, let’s say you loaned £10,000 for a new car on a three-year PCP (Personal Contract Purchase) finance deal – that includes an £8,000 balloon payment. As the contract ends, you may want to pay the balloon payment and own the car, but the vehicle itself is only worth £7,500.
So you will owe £8,000 on a car that is only valued at £7,500. You will therefore have negative equity. This is not as scary as it sounds, and later on in this guide we explain what that means for you.
A loan-to-value ratio (LTV) is the easiest way of working out how much negative equity you have, if any. You can use the simple formula, (amount owed / value) x 100, to give you the percentage of equity you currently have. Any figure below 100% is positive equity, and anything above 100% will mean you have negative equity.
Using our example from earlier, (8,000/7,500) x 100 = 107%. Your LTV in this case would be 107%, meaning you would have negative equity.
What this looks like on a car’s value
As we’ve mentioned, depreciation tends to accelerate as soon as you drive away in your new car, but will slow down over the duration of the agreement. Presuming you keep the car in good condition. So while your equity may be negative for the early months, it is likely that your monthly repayments close that gap.
Going back to our example, say you have come to the end of your agreement and want to pay the £8,000 to own the car outright. Except this time the car has been kept in good condition and is well under the mileage cap – meaning the value of the car is actually £8,500. Working out your LTV would look like this, (8,000/8,500) x 100 = 94%. So now, because the depreciation has slowed down and your monthly payments have continued, you now have positive equity.
This is not always the case though, and if the value of the car continues to drop faster than the rate of your repayments – you may have negative equity for much longer.
Why is negative equity on my car a problem?
You might be wondering where the problems arise from negative equity since you are hiring the car. But it can affect you if you aren’t aware of it.
If you were to have an accident and the car ended up being written off, insurance companies usually only pay out the market value of the car at the time of your claim. In this situation you’re left to make up the difference to your lender out of your own pocket. That is the case with all types of car finance, and will affect you whether you take out a lease, PCP, or hire purchase deal (HP).
If for whatever reason, you can no longer afford your monthly repayments, you can normally sell your car and pay off the remaining debt. However with negative equity, you may not be able to recuperate the amount of loan outstanding. So problems may arise if circumstances do change.
Negative equity will have slightly different effects depending on the type of finance agreement you take out.
Negative equity on a lease
Car leasing is possibly the simplest form of finance with regards to negative equity – because it has almost no effect. Yes, negative equity will likely exist over the course of your lease agreement but because you won’t be owning the car after the deal has ended you won’t need to concern yourself with its value, provided you keep it in good condition as expected.
Your only problem arises if you were to have an accident, as we’ve mentioned insurance companies will often only pay out the value of the car, not what you owe. However, extra cover such as GAP insurance can protect you in these circumstances as a provider will make up this shortfall.
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Negative equity on PCP
Because there is more flexibility with your options after a PCP deal, negative equity could cause some complications towards the end.
If you are planning on handing your car back, as you would with a lease, there is no effect. As any negative equity is passed on to the dealer.
If you had previously planned on using any positive equity towards a deposit on a new deal, any negative equity will eliminate that possibility. You won’t have to pay the difference between the Guaranteed Minimum Future Value (GMFV) and your equity, but you will have to come up with the full amount of the new deposit.
Finally, if you decide to keep the car, you’re also free of any charges, but you will have to pay the pre-agreed GMFV, regardless of the car’s value. In some cases, you may be able to negotiate a smaller fee with your dealer so it is always worth having those conversations.
Negative equity on HP
With a hire purchase, you are paying off the full value of the car throughout the agreement, and will only pay a small option to purchase fee at the end of the loan. Therefore there is no need to worry about negative equity, unless you have an accident.
When you come to the end of your agreement, you won’t face any additional costs and if you enjoy driving the car and want to keep it, negative equity won’t be an issue.
What to do if your car finance deal has left you with negative equity?
So what do you do if you find yourself in negative equity come the end of your deal? Well in most cases you don’t need to do anything at all. Either hand the car back, or keep it based on your agreement. You won’t have to pay any extra fees just because you had negative equity.
If your circumstances have changed and you can no longer afford the monthly repayments, you can terminate your contract. Providing you have paid 50% or more of its total value, you can opt to voluntarily terminate the contract. Meaning you can simply hand the car back and walk away with no extra costs.
Can I take out a new car finance agreement?
After you have handed your car back, you are free to take out a new car finance agreement. Because you have no equity to rollover into a new deal, you will have to pay the deposit in full yourself.
You can take out a new car finance agreement during your current deal, but any negative equity will be lumped on to the new agreement. Not really solving your problem, and in most cases worsening it.
How do I protect myself against negative equity?
There are certain steps you can take to protect yourself against negative equity if you are particularly conscious about it.
1. Choose a bigger deposit
One simple way to reduce the risk of negative equity is paying a bigger deposit. The larger the deposit, the smaller the amount you will need to pay off. Therefore making it harder for the value of the car to fall lower than the outstanding amount. Reducing the chances of negative equity.
2. Consider GAP insurance
If paying a larger deposit is not possible for you, one other option you could look at is GAP insurance. If you have an accident while you’re in negative equity, GAP insurance will cover you for the difference. So you won’t have to pay it out of your own pocket.
Want to find out more about GAP insurance? Check out our handy guide to this optional cover.
Want a free GAP quote for your finance car? We’ve partnered with the UK’s number one GAP insurance provider, DirectGap, to offer you cover from 1-5 years on Hire Purhcase, Personal Contract Purchase and Personal Contract Hire (leasing) agreements.
3. Avoid depreciation by caring for your car
Depreciation is the biggest contribution towards negative equity. There are small things that you can do to slow down the rate of depreciation, and therefore reduce the risk of falling into negative equity.
Keep your car in good condition, reduce the number of miles you are driving, or even consider buying a used car instead of a new one. All of these things can be done to slow the rate of depreciation down.
With car leasing you don’t need to worry about negative equity as set monthly payments cover you for the cost of hiring before handing the car back. Compare lease offers on major manufacturers at Moneyshake and get started today.
Want to know how often you should maintain your car? See our guide explaining when to do maintenance on your car. Or if you need more information on car finance and leasing before deciding, head over to our guides page for everything you need to know.
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