If you are considering applying for car finance, one thing you should know about first is the issue of negative equity. In this guide, we look at what this is and tips for how to avoid it.
Overview of Negative Equity
First, you need to know what equity is. Equity is essentially the difference between what something is worth (in this case, your car), and what you owe on your loan.
If your car is worth more than what you owe, this is positive equity (or just equity). If your car is worth less, this is negative equity.
For example, if you still owe £4,000 of your loan and your car is worth £8,000, you could sell your car, pay off your loan and have money (equity) left over.
The opposite is true for negative equity because if you sell your car, you are still left with money to pay off on your loan.
Problems Associated with Negative Equity
If you pay off your loan as arranged, negative equity is not normally a problem. The problem occurs if there is a change in your circumstances.
For example, you may lose your job and you can no longer make your payments. You then sell the car, but you will still owe money because you cannot pay off the debt.
If you default on your debt, late fees will apply and then your debt increases. Your credit score then takes a hit, and this can lead to a downward spiral.
How to Minimise the Risk of Negative Equity
It’s clearly in your interest to minimise the risk of negative equity. Remember, however, that it is usually unavoidable at first. Until you have paid back about two thirds of your loan, you may have negative equity because your car is a depreciating asset.
To minimise the risk, only get a loan if you can afford the repayments. This is the most important thing of all.
Ensure you will have extra money each month after making your payment for other expenses.
A short-term loan can also help to avoid negative equity.
You will also pay higher monthly payments, but then if you do experience financial problems in the future, you will have less negative equity as a result.
You could also pay a larger deposit. The more you put in, the smaller the loan, the less you repay.
A smaller loan also means less interest, so try to borrow as little as possible.
Finally, try to stick with your car and avoid getting a new one too soon.
Don’t change it if you can help it because if you sell it before you pay off your loan, there is more chance of negative equity.
Know the Risks Before Applying for Car Finance
If you are considering applying for car finance, always think very carefully about your decision.
The same is true whenever you are considering a loan of any kind.
Know the risks associated with negative equity, and go in fully informed.
Most importantly, only apply for car finance that you know you can afford to pay it back on time.