Negative Equity – how to deal with it & ways to avoid it.
As instances of negative equity increase, we take a look at what negative equity is, the best strategies to avoid it and the best tactics to resolve it.
Since the credit crunch, the ways that car buyers pay for their vehicles has changed significantly.
The PCP (Personal Contract Purchase) has been around for over 25 years in the UK and is now the preferred payment method of the majority of private car purchasers. Whilst PCP has enabled many to drive and enjoy cars that they previously might not have been able to afford, changing consumer behaviour in the form of shortening car change cycles mean that more and more car owners are finding themselves in negative equity.
“Equity” – In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. (Source – Wikipedia)
If you own a car worth £55,000 and you have £50,000 of outstanding finance on it, then you have £5,000 of equity. This equity can be realised when you part-exchange or sell the car.
What is Negative Equity?
Negative equity in car finance refers to the situation where the amount owed on the vehicle is greater than the vehicle’s value. For example, the owner of a car worth £50,000 which had £55,000 of outstanding finance would be in negative equity to the tune of £5,000.
This happens because the car is depreciating faster than the loan is being paid off.
I’m in negative equity – what should I do?
Don’t panic – negative equity really only becomes an issue if you want to settle your finance agreement early. That could be because of a change in circumstances or simply because you want to change your car.
Keep your car
Either until you are no longer in negative equity, or until the agreement is finished. With a PCP this means that you will be able to hand the car back at the end of the agreement with nothing more to pay.
Don’t compound the problem
“Lump & bump” is the practice whereby a dealer will increase the price of a car they are selling to cover any negative equity. For example, if you wish to buy a car for £50,000 and have £5,000 of negative equity in your part exchange, then the dealer may offer to sell you the car for £55,000 to cover that negative equity and increase the amount financed. In reality, you will simply be compounding the problem by paying more for the car than it is worth and being charged even more interest, which is likely to leave you in….? – You guessed it – negative equity – and this time even more than before.
Watch out for – an additional 20% on the invoice price to cover the VAT on the dealer’s profit. On the above example that could mean an additional charge of £1000.
Pay off the negative equity if you can
Whilst many people may be unable to do this, paying off the negative equity amount will give you more flexibility when purchasing your next car and will avoid compounding the problem in the future.
Under certain circumstances it is possible to refinance a car using more favourable terms and a more structured approach to reduce exposure to negative equity.
How to avoid negative equity?
Plan your ownership cycle
If you like to change your car every two years, then you should take an appropriate finance agreement that will allow you to do this without leaving you in negative equity. On a two-year change cycle, a four year PCP may not be the best car finance product to choose! Plan to have some equity at the point you think you will wish to change by ensuring your initial deposit and monthly payment will allow this.
You can plan ahead using our car finance settlement calculator.
Are your monthly finance payments lower than the monthly depreciation on the car you are buying?
Are you putting down the smallest possible deposit and trying to get a large final balloon payment to keep your monthly payments low?
Then negative equity may become an issue. Unfortunately, many buyers are encouraged down this route by dealers wishing to sell cars and some finance companies will offer unrealistic final balloon payments to encourage them to sign up. Beware.
A finance agreement regulated by the Consumer Credit Act will give you the option to settle your finance early. Finance agreements that are not covered by this regulation may not offer an early settlement option and if they do there could be significant penalties which can compound any negative equity you may already have. If a regulated agreement is available – take it.
Regulated vs unregulated finance agreements
Beware big discounts
A big discount on a car and a low rate finance deal to encourage you to buy might sound great, but this can indicate that the car you are buying is not a good seller and therefore the residual values may be poor – one of the main causes of negative equity.
If you have a regulated finance agreement, you have the option to hand the car back to the lender once you have paid half the Total Amount Payable (this includes the amount financed plus any interest and charges). This is called Voluntary Termination and is a consumer’s legal right.
Whilst doing this will not affect your credit rating, the finance company may make a note on your credit file which could lead to them or other finance companies declining further applications from you. If you do intend to terminate the agreement in this way, you should get the finance for your next car in place before you do so.
As with any finance agreement, you should always keep up your finance payments even if you are in negative equity.
No-one wants to be in negative equity but for many car owners it is now a fact of life despite the fact that is is easy to avoid if you plan ahead and purchase the right car using a carefully considered finance product.
Please contact our finance team for more information on 01943 660703 or request a callback.