Drive One, Pay for Two

by MB on February 19, 2009 has nice article on dealing with another bubble that inflated during the times of easy credit: negative automobile equity. The article states that as much as 25% of all automobile borrowers are “under water.”

Here’s how that works: The value of the trade-in is $8000; balance on the loan for that trade-in is $10,000. That leaves a $2000 deficit that either a) the dealer eats (unlikely), or b) you have to cover with an extra cash down payment as well as the trade, or c) gets rolled into the new car loan. The last option means that you are essentially refinancing the remaining debt on the car you just sold back to the dealer, along with the price of the new car and whatever add-ons get added on back in the F&I office.

I know from several acquaintances in the automobile retailing industry that this type of thing happened a lot.

As cars get more expensive, and loan terms get longer (to keep those monthly payments affordable!) that increases the odds of negative equity caused by left-over debt from the trade-in. In theory, the lenders financing those loans would want to know if the car was going to be underwater due to negative equity before it even drove off the lot. But in practice – just as with the mortgage industry, the only thing worse for your monthly numbers than an undersecured loan was no loan at all.

This is classic example of misaligned priorities: it was better to do a bad deal than no deal at all.

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