Car Negative Equity Explained

When you hear the term negative equity, you’re most likely to think of it in terms of property. But did you know it can also apply to cars? When it comes to property, negative equity is when a home is worth less than the outstanding mortgage balance. While it doesn’t sound ideal, it’s only really a significant issue if you wish to remortgage or sell.

Negative equity with cars is less common, but it can happen. Below are the most common circumstances when car negative equity is likely to occur. You can also find out what you can do to avoid it happening to you.

Why is negative equity not that common with cars?

When it comes to car finance, negative equity isn’t really an issue. This is because in most cases, the cars purchased privately in the UK are done so with a Personal Contract Purchase (PCP) agreement. In this agreement, there is a guaranteed minimum future value (GMFV) placed on the car, which is the minimum amount a car is expected to be worth at the end of the agreement.

Therefore if the terms of the deal are adhered to, it’s not possible to get into negative equity. Normally a PCP agreement consists of the following three parts:

• Deposit
• Monthly payments
• Final payment

Over the course of the agreement, the deposit and monthly payments will cover the depreciation of the car. The final payment (often referred to as the balloon payment) is based on the cars GMFV. This amount is predicted based on previous values of similar cars.

Of course it’s possible that a car will be worth less than the GMFV at the end of the lease. Any shortfall between the GFMV and the actual value is called negative equity. This isn’t a problem for the person leasing the car, because the GMFV was set in a contract. The company providing the finance is responsible for the shortfall.

How do you get into negative equity?

You may have heard the saying that a car loses value as soon as it’s driven from the showroom. This is true. A car takes it’s biggest depreciation hit during the early months. As time goes on, the depreciation gently decreases. However with a new car that you’re leasing there’s often at least a brief amount of time when the amount you owe for the car is more than it’s actually worth.

In theory, most PCP customers are in negative equity for the beginning part of their contract. However when the end of the contract comes around, depreciation is less rapid and the customer has paid off more of the balance. And if there is a shortfall, it’s contractually the problem of the finance company, not the customer.

This is why the monthly cost will always be higher for a 24-month lease than 36 months. A two year agreement sees a larger percentage of the car’s value being eaten by depreciation. This means the finance company would lose money if they didn’t increase the monthly cost.

GAP Insurance

If during a PCP contract your car is stolen or written off, then you may find that the insurance company pay out less than what you owe to the finance company. This is because the insurance company will only pay out the market value for the car. As mentioned earlier, cars depreciate quite heavily when they are new. In this example it is the responsibility of the person leasing the car to pay the shortfall to the finance company. You are then effectively in negative equity and with no way to rectify it.

As you can see if you’re unfortunate enough to have a total loss on a very new and expensive car in the early months of a PCP agreement, it could get rather expensive for you. This is where GAP insurance comes in very handy.

Guaranteed Asset Protection (GAP) insurance is an insurance that will cover the shortfall in the above scenario. When taking out a PCP contract GAP insurance is always recommended as it prevents the need for you having to pay potentially thousands of pounds to the finance company should you suffer a total loss with the vehicle in the early months of the agreement. When you consider how much money it could potentially save you, GAP insurance is inexpensive and we would advise taking out a GAP insurance policy in virtually all cases.

Selling a car with negative equity

If you want or need to sell a car when you are in the middle of an existing finance contract then you may owe more than the car is currently worth. It’s unlawful to sell a car with outstanding finance in the UK. So you will need to make sure the finance is settled before putting the car on the market. Upon doing so you will then find that you are in negative equity because the car has cost you more than you will be selling it for.

It’s worth noting that the majority of PCP contracts require you to keep the car for the duration of the agreement. This is because they have already made arrangements for the car when you hand it back. Always check the small print in your PCP contract before attempting to sell a vehicle on finance.

Early exit from a car lease

It is possible to end a finance contract early providing your personal circumstances have changed and you are unable to afford the monthly repayments on your lease. As long as you have paid off 50% or more of the total finance amount, you can cancel the agreement as per the Consumer Credit Act. The total finance amount includes fees, interest and the final (balloon) payment.

What if I haven’t paid 50% of the total finance?

If you wish to terminate the contract but have not yet paid off 50% of the finance, then you could find that the amount you owe on the car is more than the current value of it. You would therefore be in negative equity and your finance company will ask you to pay the shortfall.

What if I can’t afford the shortfall?

There are companies out there who will lend the money to cover the shortfall when in negative equity with a car. This means that you can terminate the contract and walk away. This is known as negative equity finance. Be warned though that interest rates for these type of loans can be significantly higher than for other loans.

Negative equity with HP

A Hire Purchase (HP) agreement is different to a PCP agreement. This is that there is no final payment at the end. The amount of finance is divided equally into monthly payments over the duration of the agreement. In order to terminate an agreement with an HP agreement you will still need to have paid off 50% or more of the total finance you took out.

As with a PCP deal if you have not yet paid off 50% of the finance then you will need to make up the shortfall, as well as give the car back. This effectively leaves you in a negative equity situation.