When talking cars and auto loans, equity is the difference between the resale value of the car and the amount you owe on it. It's a way of quantifying the portion of the vehicle that belongs to you outright while you're in the process of paying off your car loan. Equity can be expressed as a dollar amount or as the percentage of the car's current resale value.
Equity can be positive or negative. You have positive equity in your car when it's worth more than the amount you owe on it. If your car is worth less than the amount you owe on it, you have negative equity (and your loan is considered underwater or upside-down). There are a number of reasons you could end up with negative equity on a car loan, but common ones include excessively high mileage on the vehicle during the loan period, accidents, or mishaps such as flooding or theft that significantly lower resale value.
How Do I Calculate My Car's Equity?
When you're trying to determine how much equity you have in your car, it's easy to find the "what you owe" part of the equation. Consult your loan payment ticket book or the website where your auto lender lets you make payments, and you'll see a running tally of the number of payments you've made, the number remaining on your loan, the total you've paid to date and the amount you still owe on the car.
It's trickier to figure out what your car is worth, because all vehicles lose value as they age, and a variety of factors affect their resale value. Some car models are just more popular than others and tend to hold their value better over time. High mileage tends to lower resale value, while unusually low mileage can help retain it. If the car has been in an accident, that can lower its resale value even if you've made full repairs. And of course, some crashes result in total loss, effectively reducing the car's value to zero (other than its value as scrap metal).
Good resources for determining your car's value include the Kelley Blue Book and Edmunds websites. When you fill out the forms, make sure you're accurate about mileage, optional features and trim details that apply to your car, and be realistic in your assessments of the vehicle's condition. Alternatively, many car dealers will give you a free appraisal on your vehicle, based on current market conditions in your area.
Here's an example, using round numbers: Let's say you've financed a 1-year-old used car priced at $20,000. The trade-in value of your old car and your cash down payment totaled $4,000, so your auto loan amount is $16,000. At 4.5% interest with a 48-month repayment period, your monthly payments will be just under $365, and the total amount you'll pay over the course of the loan will be just over $17,513. (If you pay off the loan ahead of schedule, you'll pay less than that, but let's assume for purposes of this example that you're just making the required payment every month for four years.)
- On the day you take possession of the car, before you even make a payment, your $4,000 trade-in and down payment will give you a chunk of equity in the vehicle equal to the cost of the car minus the total loan amount ($20,000-$17,513): $2,487, or about 12.4% of the car's value.
- At the midpoint of the loan repayment period (after 24 months and 24 payments), you'll have paid just under $8,757, and you'll owe essentially the same amount on the loan. But the car will be 3 years old at that point, and you'll have racked up miles and maybe even a few dings and scrapes (or worse), so its resale value will be less than you paid for it.
The details on your car's condition and mileage will determine its actual value, but a good general rule on used cars is to estimate a loss of 10% in resale value every year. So let's assume the car you bought for $20,000 has a resale value of $16,000 after two years. Your equity equals that amount minus the balance on your loan ($16,000-$8,757) or $7,243—just over 45% of the car's resale value.
- Of course, at the end of the loan period, when you owe nothing more on the vehicle, your equity is 100% of its resale value, whatever that may be.
How Can I Use My Car's Equity?
If you have negative equity in your car, your options are limited. You can ask your lender to consider working with you to come up with more favorable loan terms (it's a long shot, but it can't hurt to try). If you have good credit, your lender may offer to let you take out a loan on a newer car that covers the cost of the new vehicle and the amount you still owe on the old car, less the trade-in value of the old car. In some cases, however, that means starting out with negative equity on the new car, with the expectation your payments will catch up over time. That's not great footing to start out on a loan, and the possibility of an accident makes it a risky proposition.
Your best bet in a negative-equity situation may be to pay off the loan as quickly as possible to avoid throwing good money after bad. You can sell the car, but since the lender holds title to the vehicle, they'll collect whatever you get for it, and you'll still owe whatever portion of the loan amount the sale doesn't cover. And you'll also be out of a car.
A common strategy for hedging against the possibility of negative equity is a special type of insurance known as guaranteed asset protection (GAP) coverage. If your car is declared a total loss following an accident or theft and the car is worth less than you owe on it, a GAP policy pays the difference between what you owe on your loan and the car's value (possibly less a deductible amount). Note, however, that a GAP policy will not make up a negative-equity difference if you sell or trade in your car.
If you have positive equity in your car, you may be able to refinance your auto loan after a year or two at a better interest rate or use your car as collateral for a personal loan. Be careful using the car as collateral, however, because if you do so and fail to make payments on the personal loan, the lender could take possession of the car.
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