It's a situation many Canadians find themselves in: you owe more on your car loan than the car is actually worth. This is called having 'negative equity,' or being 'upside down' on your loan. It can feel like you're stuck, especially if you need a new vehicle. A negative equity car loan is a common way to solve this, but it's important to understand exactly how it works.

What is a Negative Equity Car Loan?

A negative equity car loan isn't a special type of loan. It's simply when a lender agrees to add the remaining debt from your old car loan onto the loan for your new car. You trade in your old vehicle, and the negative equity is 'rolled over' into the new financing agreement.

Let's look at a simple example:

• You owe $15,000 on your current car.
• The dealership offers you $10,000 for it as a trade-in.
• This leaves you with $5,000 in negative equity ($15,000 - $10,000).
• You want to buy a new car for $25,000.

The lender would add your $5,000 negative equity to the price of the new car. Your new loan would be for $30,000 ($25,000 + $5,000), plus any taxes and fees.

Why Does Negative Equity Happen?

Being upside down on a car loan is surprisingly common. It usually happens for a few key reasons:

• Rapid Depreciation: Cars lose value the fastest in their first few years. Your loan payments might not keep up with how quickly the car's market value is dropping.
• Long Loan Terms: Financing a car over 72, 84, or even 96 months means your monthly payments are smaller, but you build equity much more slowly. For the first few years, your payments are mostly covering interest.
• No (or Low) Down Payment: A small down payment means you're financing a larger portion of the car's value from day one, making it easier for the depreciation to outpace your payments.
• High-Interest Rates: If you have a high-interest loan, more of your payment goes toward interest instead of paying down the principal balance, slowing equity growth.

The Pros and Cons of Rolling Over Negative Equity

While rolling over your negative equity can get you into a new car when you need one, it comes with significant trade-offs. It's a tool that can help, but it must be used carefully.

The Upside:

• Immediate Solution: It allows you to get out of your current vehicle and into a new one without having to pay a lump sum of cash to clear the old loan.
• Convenience: It consolidates your old car debt and new car purchase into a single monthly payment.

The Downside:

• Higher Payments: Your new loan is for more than the new car is worth, which means a higher monthly payment and more interest paid over the life of the loan.
• Paying for an Old Asset: You are essentially paying interest on a car you don't even own anymore.
• The Cycle Repeats: It starts you off with negative equity in your new car, making it very likely you'll be in the same situation again when you want to trade it in next time.

Alternatives to a Negative Equity Loan

If you're upside down, rolling the debt over isn't your only option. Consider these alternatives first:

• Keep Your Current Car: If the vehicle is still reliable, the most financially sound decision is often to keep driving it and make extra payments to pay down the principal faster. Once you have equity, you'll be in a much stronger position.
• Pay the Difference in Cash: If you can, sell your car privately (you'll usually get more than a trade-in offer) and use savings to pay the difference between the sale price and what you owe.
• Wait and Save: Postpone buying a new car. Continue making payments on your current loan while saving up for a larger down payment on your next vehicle. A big down payment is the best way to avoid negative equity.

Is It the Right Choice for You?

A negative equity car loan can be a necessary step if your current vehicle is unreliable or no longer meets your family's needs. However, it should be seen as a short-term fix, not a long-term strategy. If you do choose to roll over your debt, try to select a shorter loan term for the new vehicle and aim to make extra payments whenever possible to break the cycle of being upside down.