When you get a loan to help you buy a car, it’s important to understand what you’re signing up for. If you think you can just keep trading in cars through leases and not lose money, you haven’t been told about negative equity.
Negative equity is when the actual value of what you own is less than the money that you owe on the loan or lease used to buy it.
That means the current market value of your car has fallen below what you still owe – but you have to keep paying that loan even though, in theory, you’ve already covered the actual price of the vehicle.
That’s why it’s important to understand how leases and loans work, and to be careful when you’re offered a long-term loan to buy something you likely can’t afford.
A bank or car dealership will offer to lend you the money you need to either lease or buy the vehicle, which you then pay back in instalments.
If you’re buying the car, you’ll borrow money at a set interest rate and then pay back the amount you borrowed, plus interest. Once you’ve paid the loan back, the car is yours. You’ve paid the principal balance (the actual price of the car) as well as the interest and you’re home free.
If you’re leasing, you’re basically renting the car. The leasing company (bank or dealership) owns the car, and they’re letting you use it, under certain conditions. These typically involve keeping the odometer under a certain reading and making sure the car gets proper maintenance.
At the end of the leasing period, you usually have the option to return the car and take on a new lease, or buy the dealership out. That way, you end up owning the car instead of taking on a new lease.
Since you’re dealing with a lease, not a loan, you don’t have to pay back the full dollar amount you borrowed – say $13,000 plus interest. All you have to pay back is enough principal to get to the value of the car at the end of the lease. If the leasing company thinks that at the end of the leasing period the car will be worth $7,000, when your lease is up, you can pay $7,000 on top of what you paid over the leasing period to own the car.
But cars depreciate in value over time, so the car itself may end up being worth less than the remaining principle on the loan or lease.
That means that after you’ve been paying to use the car – both in lease payments and interest – if you want to own it, you have to pay the leasing company the $7,000 it estimated. That amount remains set even if the car is by now only worth $5,000.
You may also have been paying more than you meant to if you initially got talked into a longer loan. Let’s say you were looking to buy a $20,000 car that came with payments of $150 every two weeks. You ended up getting talked into a nicer car, because it was just an extra $30 a month (at $165 every two weeks). You didn’t think that was a big difference.
Yet the new car was actually worth $30,000, not $20,000 – so you had to pay that $165 bi-weekly over seven years, not five. It may “just” have been an extra $30 a month – but you paid it over an additional two years.
In the end, you found yourself with a lot more debt for a car that ended up being worth a lot less – because of negative equity.
So before you sign any lease or loan, make sure you understand the price – and value – of the car, as well as the different rates and deals available based on different lengths of amortization and interest rates.
Otherwise, you may end up paying more money for longer – and still have to pay more than the car is worth if you want to own it in the end.