Negative Equity Car Leases

So, you’re looking to lease a new vehicle. Perhaps, you’ve grown tired of your current car. Maybe it doesn’t suit your needs any longer, or you’ve come to regret some of its features or the lack thereof.

A big factor in estimating the cost of your next lease is the value of your current one.

The trade-in value of your car can dramatically reduce the cost of your next one, but not always. Depending on the current situation of your car loan, lease or loan term interest rate, and remaining balance, you may find yourself owing more money to the bank than your vehicle is worth.

There’s nothing more disappointing than meeting your car dealer, fully prepared to negotiate after painstakingly comparing vehicles and lease configurations, only to find out your current car is worth minus $3,000.

Yes, you read that right, your vehicle can have negative equity, despite being roadworthy. Heck, it can be in perfect condition and still hold you back several grand.

Let’s take a step back and explain what equity is and how it affects leasing a new car.

What is the equity of your leased car?

In the finance world, equity signifies how much of an asset you  own after all debts, liabilities, liens, and credits are accounted for.

Equity is very important when negotiating a new auto loan or lease contract as it can be used to offset some of the capital cost of the vehicle. This can go both ways – you can win a reduction in price or have to pay extra, depending on your equity.

To calculate the equity of your vehicle, there are three figures you need.  The current real-world value, the remaining balance on your lease or loan balance, and the total payoff amount. There are several sites like Edmunds that offer calculators and tools to help determine your car’s value.

Market value vs Residual value vs Payoff amount

The market value for any given vehicle can be obtained by simply driving to a few dealerships around your area and asking them for a trade-in evaluation.

Online appraisal tools can give you a fair estimate, but those may or may not be accurate on a case by case scenario.

Remember, the true market value is only what somebody is willing to pay for a vehicle. Any figure is irrelevant unless it’s written on a check or bank statement.

Leasing companies are exceptional at predicting how the market value of your car will change at the end of the lease. Their best estimate is the residual value, listed in your leasing contract.

If you want to keep the vehicle after the lease, you can simply buy it off the leasing company for the residual value. However, if you want to buy the car before the end of your lease, you need to obtain the payoff amount.

This is simply the remainder of your lease payments added to the residual value, adjusted for the reduced lease term. The payoff amount changes every day, but you can simply call the leasing company and ask for it.

At the end of your lease, the payoff amount is exactly equal to the residual value and usually very close to the current market value.

What do these have to do with equity?

Well, your equity in the vehicle is simply the difference between its market value and the payoff amount.

Positive equity

If you own your car outright with no loan balance or leases to pay off, then the equity is exactly its market value.

For example, a used 2017 Mercedes Benz C300 is worth around $20,000. That’s a positive equity of $20,000.

Let’s take the same market value, but this time consider an active lease with two payments left at $500 each, and a residual value of $17,500. The leasing company sets the payoff amount at $19,000.

Suddenly, you have the opportunity to make an extra $1,000 by buying out and reselling your leased Mercedes. OR, you use that positive equity to trade it in for another leased car and knock $1,000 off the initial price.

Any time you can resell or trade-in your vehicle for more than it costs to buy it off the leasing company, you have positive equity.

Negative equity

Negative equity is the exact opposite of positive equity – you owe more money to your leasing company or on your car loan than the vehicle is worth on the market.  This is sometimes called being in an “upside-down car loan” or lease.

For example, you drive your 2017 Lexus GS to a dealership for a trade-in evaluation and they offer you $18,000.

You have 5 lease or car payments left at $450 and a residual value of $17,400. The leasing company sets the payoff amount at $20,000.

If you trade in now, you’ll have negative equity of $2,000. Some dealers also refer to it as an “upside-down” lease.

Each way you look at it, you’re two grand short.

Most common factors for negative equity car leases

Lessees usually hold negative equity throughout most of their term. Leasing companies estimate the residual value to be equal to the market value at the end of the lease term. So, theoretically, you break even when the lease ends and never get to accumulate equity.

After all, if you paid less than what the vehicle is worth on the market, leasing companies wouldn’t be doing a very good job at generating profit.

That said, some factors that make it harder or easier to build equity.

1. High starting price – if there are no price negotiations, no down payment, and no trade-in value from another vehicle, the lease balance holds a lot of capital, which will accrue a lot of interest.
2. High money factor – more money factor means even more interest.
3. High depreciation – if your car is declining on the market faster than average, it’s even more difficult to break even.

Some of these factors you can affect. Others are largely out of your control. It’s difficult to plan for equity, but if you keep the total cost of your lease low, it should be easier to break even.

How does negative equity affect your new lease?

Negative equity is money you owe. No bank or leasing company will pay it for you. They can only mask it, but in reality, it only gets more expensive, even with a new car loan or lease.

There are only two possible ways to deal with a negative equity car lease.

Rolling negative equity into the next car lease

If you have a small amount of negative equity, the dealership will usually agree to roll it into your next lease.

What this means is they will add that negative equity to the starting price of the new leased vehicle or a new loan. This value will then get adjusted with other factors to form the net capitalized cost.

Interest is then charged on top of the whole sum, increasing the total cost of the new lease.

The leasing company can offer the same monthly payment, however, you will have to make a compromise either with a cheaper car, longer-term or lower mileage cap – possibly a combination of the three.

This usually happens when the negative equity is less than 10% of the MSRP of your new leased vehicle. Any more and finance providers get sweaty hands as they’re asked to pay significantly more than the product is worth, thereby increasing their risk.

If you hold negative equity of several thousand dollars and an average credit score or worse, there is a real chance to get rejected.

Paying negative equity upfront

If you have five-figures of negative equity, you probably won’t be able to trade-in your car unless you offer significant down payment to make your case more favorable.

From a financial standpoint, it’s best to keep your current vehicle and finish your lease.

If you can’t or won’t keep the car AND you have the money, it’s cheapest to simply pay off the negative equity before starting a new lease.

That said, cheaper is not always best.

Paying off the negative equity outright can give you the confidence to negotiate on a clean plate and possibly secure a better deal.

On the other hand, paying a large sum in cash isn’t always possible and it carries an increased financial risk. Rolling over the negative equity will be more expensive, but you can pay as you go and keep on to your money to invest elsewhere.

Interest

Negative equity is added to the capital cost of your new leased car and will be obliged with interest in the same fashion. The total cost of your new lease will increase, even if the monthly payment stays the same.

This can go in a vicious circle from lease to lease. The negative equity from your first lease will collect interest on each consecutive lease, therefore increasing your debt – slowly, but surely.

Insurance

If your leased vehicle is totaled in an accident or is stolen, the insurance company will pay only for the cost to replace it, which is usually close to its current market value.

If the lease has absorbed negative equity from a prior vehicle, there will be a significant gap between what the insurer pays and what the driver still owes to the leasing company.

When rolling the negative equity into a new car lease, make sure to get GAP insurance. Although it will increase your running costs, it will save you from the financial impact of a total loss.

Bottom line

Okay, what did we learn?

Negative equity results from owing more money to the leasing company than the vehicle is worth on the market.

If you want to trade-in early, you have to take into account how much equity you bring into your next lease. Usually, small amounts of negative equity can be rolled into the next one with a slight bump in price.

Larger amounts of negative equity can drastically affect the price of your next lease or even the ability to acquire one. We don’t recommend rolling a large amount of negative equity more than once in order to limit the financial impact.

When rolling negative equity to another car lease, make sure your next vehicle is affordable and will suit your needs in the long term. It’s advisable to keep the second vehicle for the full lease term and clear your negative equity entirely, before proceeding forward.