Have you seen auto dealerships’ ads and mortgages promising to pay off your loan balance when you trade in an asset? However, some buyers owe more than the value of their trade-in, resulting in negative equity. So, how much negative equity will a bank finance? First, keep in mind that banks will often want to avoid negative equity situations, especially amidst turbulent economic times.
The reason is that the asset is the only collateral the lender can take if the loan defaults. And in an economic downturn such as a job loss, lenders have to think hard about financing in an upside-down loan situation. So, the higher your negative equity, the riskier your loan is, and the more challenging it becomes to secure the funding.
Also, remember that if you have a lot of negative equity, lending institutions may only finance the old asset. Besides, negative equity is going to impact your interest rates. On the other hand, having stellar credit is always king. It can qualify you for financing with an attractive APR, despite carrying negative equity.
What is Negative Equity?
It’s a financial term you must understand, especially if you plan to finance your next car or home. Here is what the name means.
Negative equity is what happens when an asset is worth less than the amount you owe on the first loan to purchase it.
“Upside-down” and “underwater” are other names used to refer to negative equity. The following are factors contributing to negative equity, although there’s a section talking about that in-detail further below.
- Low or no down payments.
- Excessively stretched loan terms.
- Depreciating market value for the asset.
While an upside-down loan can happen with any asset, it’s particularly commonplace with homes and cars, especially those financed with low or no money down.
Remember that the value of a new vehicle falls as soon as you drive off the auto dealership’s lot. It automatically puts you at risk of being underwater. Opting for a shorter mortgage or auto loan is one way to prevent negative equity. You’ll be able to clear the balance off more quickly. Paying a larger down payment is another way to minimize that scenario.
Example of Negative Equity
If you buy an auto or home with minimal money down, you risk creating an upside-down loan. It may not be an issue until you need to trade in or sell that asset.
Say you buy a $20k vehicle with a fully-financed auto loan and no deposit. After keeping the car for two years, the value drops to $15k, and you owe $18k. It will create a $3k negative equity.
But you want to obtain a more fuel-efficient model because of a longer commute. To do that, you must take responsibility for the $3,000 deficit, your negative equity. For vehicles, some dealers allow buyers to roll their negative equity into the new car loan.
The downside is that it keeps you underwater on the new auto loan from the start. It also upsurges your vehicle payments, making your new car costlier.
You can still clear the upside-down loan using cash. Suppose you cannot qualify for financing with that debt or have insufficient money. In that case, you’ll likely be unable to secure the new vehicle. That’s why it’s vital to answer the question, “how much negative equity will a bank finance?”
What Causes Negative Equity on Your Loan?
Shopping for your next vehicle or new home can be frustrating if you are underwater. It is even more challenging if you plan to finance at least part of that loan. Doing some careful planning can ensure you keep off another negative equity. We’ll be telling you why negative equity happens, how much of it can be financed in a new loan, and more.
An upside-down loan is another name for negative equity. Simply put, instead of having equity in the asset, you would owe the lender money if you sold the asset. Having negative equity happens in various ways. However, it often occurs when you trade in an old vehicle for a new one.
- Unethical loan Offers: In other cases, the dealer might act unethically and not provide full disclosure. Other times, however, it is your responsibility as a customer to go through the loan documents. Unfortunately, we sometimes don’t take the time to understand the contract’s fine print.
- Misleading Loan Ads: Walking into a dealership with a vehicle that’s not paid off, looking to get a new one isn’t uncommon. The dealer promises to arrange for an almost equivalent payment to the current auto payment. You don’t understand that they are folding the old car’s loan into the price of your new vehicle.
- Not Putting Down Money: Purchasing a car without a down payment is another way you get into an upside-down auto loan. Vehicles depreciate 20 percent within the first year and dip 50 percent by the third year. Therefore, they are a liability and not an investment. Buying a new car without a down payment leaves you carrying negative equity the moment you drive off the lot.
- Too Long Loan Terms: Taking excessively long loan terms can also put you in a negative equity situation. The terms of this loan will stretch your payments out so far that they don’t match with the depreciation.
The FTC, the US consumer protection agency, particularly cautions negative equity buyers to be extra-cautious with auto trade-in deals. The reason is that while the ad promises to pay off your previous loan, it may be misleading. Most dealerships include the negative equity in your new auto loan, significantly increasing your monthly payments. That’s because the dealer’s action adds principal and interest.
To answer the question, how much negative equity will a bank finance? Here are two essential factors that’ll determine the loan amount.
Factors That Influence Your Loan Amount
There isn’t a definite answer to the question, ‘how much negative equity will a bank finance,’ because the amount varies by buyer. The amount of negative equity you can roll into a new auto financing contract differs by lender-determined asset value and individual credit record.
While some borrowers might qualify to roll over thousands of dollars into a new vehicle or home loan, others might have difficulties getting auto-financing without putting down money to increase trade-in equity. Here’s how the two factors play out.
1. Credit History
Your credit record determines the terms of your mortgage or auto loan. Obtaining approval for as much as 120% of an asset’s worth isn’t hard if you’re an excellent credit borrower. On the other hand, you can expect approval for as low as 60% of the asset’s value if you belong among poor credit applicants.
The above percentage is what makes a loan-to-value ratio. The prospective bank reviews your credit history to set your lending risk. Having higher credit risk decreases your ability to borrow. Issues such as a history of unpaid accounts, tax liens, late payments, or judgments significantly reduce your odds of financing an upside-down car or home loan.
When purchasing a car, the price you pay for it also influences your loan-to-value ratio. Suppose you buy a $16,000 car with a $20,000 lending value. In that case, you may qualify to roll over $4,000 in negative equity to your new loan if you obtained a loan with a 100% loan-to-value ratio.
If that car were to cost $21,000 instead, you would have to put down $1,000 to satisfy the $20k lender’s loan requirement or 100% of the lender-determined value.
How To Trade In Your Asset With Negative Equity?
If you’re looking to trade in an asset while underwater, keep the following steps in mind:
1. Calculating your equity
Determining how much negative equity you have is the primary step to take. Begin by reaching your lender to see the payoff quote. After that, establish your asset’s trade-in value. Tools such as Kelly Blue Books are ideal for finding an estimated car value. Alternatively, taking the car to a dealer might give you an accurate trade-in value.
With the two numbers in hand, your negative equity amount is the auto value, less the payoff quote.
Vehicle Equity = Trade-in Value – Payoff Quote
After you find your asset’s negative equity, the lender will likely roll over that amount to your new loan.
2. Assessing your financing
When you are trading in a vehicle with an upside-down loan, you will automatically pay more to finance a new car since the loan includes what you owe. Using an auto loan calculator can help you get an idea of your loan amount.
The tools use estimated factors like loan term, Annual Percentage Rates, and trade-in value to assess your financing. While the terms are estimates, they are useful if you want a glimpse of how much you’re likely to spend on your new vehicle loan.
3. Obtaining a preapproval
Securing a preapproval is a smart move when purchasing a home or car, whether with negative equity or not. However, you’ll want to get the best terms and rates possible to afford the loan. The main reason is that you’ll be financing more because of the negative equity.
Applying with at least three different banks or lending institutions increases your chances of getting the best rates. After all the lenders responding, compare their offerings to pick one with the best terms. Also, make sure to complete all the applications within forty-five days to avoid impacting your credit. Applications completed in a short timespan often reflect as one hard hit.
4. Finding the dealer to trade in your car
Once you obtain financing, it would be time to look for a dealer to trade in your vehicle. The majority of auto dealerships will accept your car if it is in good condition. Similar to submitting a preapproval with numerous banks, consider doing the same when looking for trade-in values to secure the best deal.
More Tips To Help You Trade In An Asset With An Upside Down Loan
Apart from following through the basic process above to trade in an asset with negative equity, here are more tips to remember.
Improving Your Credit Score
Keeping a higher credit score improves your chances of getting better terms on your loan. If your scores are less-than-stellar, consider taking the time to boost your credit score before seeking a preapproval. In this way, you are likely to secure better loan terms.
Here are a few things you can do to increase your score:
- Checking your credit report to correct inaccuracies
- Reducing your debt
- Ensuring all of your accounts are not in default
When estimating your loan terms, make sure you use different interest rates to see the drastic changes in your APRs at various percentage points.
Looking for a cheaper asset
Consider buying a cheaper vehicle because you’ll have higher costs when you trade in a car with negative equity. Therefore, it makes sense to consider getting a more affordable model. It will keep your expenses on the lower end, allowing you to balance the debt on your new vehicle and the amount to pay to clear your trade-in.
Paying off the negative equity
It’s unlikely you’ll afford to pay off all of your negative equity. However, any monies you pay upfront will help to reduce the amount your new loan is financing. Many banks and lending institutions will let you pay more in advance towards your loan’s principal balance. Therefore, you are better of if you finance less.
Various factors playout to find an accurate answer to the question, “how much negative equity will a bank finance?” You stand to secure more financing with your upside-down loan if you have excellent credit. Also, pricing for the new asset you want to buy will influence how much the bank will pay for your loan. If you’re trading in a vehicle, the asset’s lender-determined value will decide how much you must pay to cover the negative equity amount.