Negative Equity

Negative equity is a term that is used when the value of an asset that is used to secure a loan is worth less than the loan balance. This happens when the asset depreciates faster than the loan value is being reduced. In the automotive business, this meaning is applied to a car that appraises for less than what the customer owes the bank or leasing company.

The history of “negative equity”

Since the 1950’s, banks and other lending institutions have been extending loan terms for automobiles. There are two major reasons for this:

Cars became increasingly more expensive and in order to secure business banks offered longer loans to make the monthly payment more affordable. Since banks compete against each other for business, the lower monthly payment usually wins and the easiest way to get there was to extend the term.

The other factor that comes into play is the captive finance company. As the car business grew, the various car companies saw the value in having their own finance companies. Not only could they make a profit on the car, they could make a profit on the financing as well. In fact, these companies could “adjust” the terms and rates on a per model basis to help “move the iron.”

The results of longer terms

With a loan term of 24 months, you are paying off about 4% of the loan principal every month. If a new car depreciates 25% the first year, you have covered that amount during the first 6 months of the loan, so after that you are in an equity position on the car.

With a loan term of 60 months, you are paying only 1.5% of the loan principal every month. With no down payment, it would take almost 17 months to hit the 25% depreciation mark, and by that time the vehicle is well into its second year of depreciation.

As you can see, extending the term puts the car owner into a downward spiral of depreciation that takes longer and longer to overcome in the payment cycle. The longer the loan, the longer the “window” of a negative difference between the car’s value and the balance of the loan.