Negative equity on a trade-in: how to find it in your contract

Negative equity, also called being "upside down" or "underwater," means you owe more on your car loan than the car is worth. It is common with long loans and cars that lose value quickly. Canada's FCAC notes that a new car may be worth 25% less than its price after one year.

Negative equity does not disappear when you trade the car in. Someone still has to pay off the old loan. The question is who, and where it shows up in your paperwork.

A simple example

The CFPB uses this example. Your loan payoff is $18,000, but your car is worth $15,000. You have $3,000 of negative equity, which has to be paid off if you want to trade in the car.

If the dealer promises to pay off that $3,000, the CFPB says, it should not be included in your new financing. But some dealers add it to the loan for your next car, or take it out of your down payment. Either way, it raises your total cost: the $3,000 joins the principal, and you pay interest on it.

To see what that costs, take a sample loan of $28,400 at 7.9% for 72 months. Adding $3,000 of negative equity makes it $31,400, raises the payment by about $52 a month and adds about $776 in finance charges. The numbers are synthetic, but the pattern holds for any loan.

Where negative equity hides on the paperwork

It is rarely labeled "negative equity." Look for these lines on the buyer's order and the loan contract:

• Trade-in allowance: what the dealer is giving you for your old car.

• Payoff, or lien payoff: what the dealer will pay your old lender.

• Net trade-in: allowance minus payoff. A negative number here is your negative equity.

• Down payment: check that it matches the cash you are actually paying. If it is lower, part of it may have been used to cover the shortfall.

• Itemization of amount financed: on a US contract, this breakdown may list amounts paid to others for you, such as your old lender. If the payoff appears here, the negative equity is in your new loan.

A sample from fictional Northgate Motors:

Trade-in allowance: $15,000

Payoff to Lakeside Credit: $18,000

Net trade-in: minus $3,000

Amount financed includes prior loan balance: $3,000

Work out your own number first

You can estimate your equity before you visit a dealer, so the figures on the deal sheet are not a surprise:

1. Ask your current lender for the payoff amount. It is often different from the balance on your last statement, because interest keeps accruing.

2. Check what your car is worth using more than one online pricing guide, and note the trade-in value, not the private-sale value.

3. Subtract the payoff from the trade-in value. A negative result is your estimated negative equity.

4. Write both numbers down and bring them with you.

If a dealer's trade-in allowance is well below your estimate, ask how it was calculated.

Watch for "we'll pay off your trade"

A promise to "pay off your trade no matter what you owe" does not mean the balance vanishes. The payoff has to come from somewhere: a higher price, a lower trade-in allowance or a bigger loan. The way to check is to compare the deal's numbers with and without the trade-in. Ask for the trade-in allowance and the payoff as separate figures, in writing.

The CFPB also suggests checking online pricing guides before you shop, so you know a fair trade-in value for your car. A low allowance makes negative equity bigger.

The risk of rolling it over again

The FTC notes that negative equity on a trade-in can increase how much you borrow, the length of the loan or your monthly payment. The CFPB says including negative equity can put you further underwater on your next loan.

FCAC adds that it takes longer to get out of negative equity on a long-term loan, which it defines as 72 months or more. If you roll $3,000 into a seven-year loan, you may still be underwater when you want to trade again, and the cycle repeats.

Options to consider before you trade

These are the approaches the CFPB and FCAC describe. Which one fits depends on your situation:

• Wait. Keep the car until you owe less than it is worth. Extra payments toward principal can speed that up.

• Sell it yourself. A private sale may bring more than a trade-in allowance. If you still owe money, contact your lender first and check your loan contract for the steps.

• Pay the difference in cash so it is not financed.

• Choose a shorter term on the new loan, so you build equity sooner.

• Avoid trading in while you have negative equity, if you can. FCAC gives this advice directly.

Questions to ask the dealer

• What is my trade-in allowance, and what is my payoff?

• Is any of my old loan balance included in the new amount financed?

• Has any of my down payment been used to cover the payoff?

• What would the price, amount financed and payment be without the trade-in?

• What is the total of payments with and without the negative equity?

Get a second pair of eyes on the trade-in numbers

When EasyToDecode opens, you will be able to upload your buyer's order or loan contract and see the trade-in allowance, payoff, down payment and amount financed pulled out and quoted from the paperwork, so you can see whether an old balance has been rolled in. See how it works or join the waitlist. For the rest of the paperwork, see our guide to reading a buyer's order line by line.