Buying a car with a car loan is a great decision for many people, as it allows them to drive the car they really want, without saving up for several years. In fact, for many people, this will be the only way to afford the kind of vehicle they always imagined driving.
But it does create some more complicated questions that you may not have considered. For example: should you pay off your car entirely before you trade it in? Let’s find out.
Cars Are Depreciating Assets
The first thing to keep in mind is that a car is what is known as a depreciating asset. That means that unlike property, or cash in the bank, your car’s overall value gets lower the longer you have it. New cars depreciate the most in the first year, and the second most in the second year. Annual depreciation starts to even out in about year four.
That means that in most cases, unless you had a big down payment or trade-in, you will owe more on the loan than the car is worth for the first few years you’re driving your car. This is what we call negative equity, or being “upside down” on your loan. It’s a really bad thing in property, but it’s fairly common in the early years with a new car.
Today, many people buy cars with no down payment, and because we want to drive a nicer car with a lower payment, we might finance the car for six or seven years. When we do that, it causes us to be upside down on our loan or have that negative equity position longer.
Now here’s the problem: if you trade in your car too soon, and you still have negative equity, you will either have to finance the negative equity into your next loan, or you will have to come up with that amount of money in cash. Depending on how much your car depreciated and how long you financed the car, that could be several thousand dollars.
If you have good credit many lenders will carry that negative equity into your next car loan. But when that happens, as your new car depreciates faster than your loan balance goes down, you have that amount plus the negative equity from your last car.
Does that mean you should always pay your car loan off before you trade it in for a new car? Not necessarily. While cars depreciate more in the first year or two, they tend to depreciate more slowly after that. Your car loan works the opposite way; it will amortize more slowly while the balance is high and more of your payment is going to interest, and then the loan balance decreases more quickly in later years as more of your payment goes to principal. At some point during the term of the loan, your loan balance and the value of your car will be equal. The timing of that will be different for every car and every loan, but when that happens, you can trade your car in with no negative equity!
There Are Other Considerations
There are other factors that can influence whether or not you should trade your car in before it is paid off. For example, most cars are out of the manufacturer warranty after three years. Obviously, repairs on cars tend to increase as cars age, and car repairs today can be very expensive. Gas prices can affect your decision to trade in your car. Perhaps your existing car is an SUV and gas prices were lower when you bought it or you’ve moved farther from where you work. Repair costs and gas, in addition to your payment, are all part of the cost of ownership. So, depending on your situation, it can make sense to trade in a car even if you still have a little negative equity.
The type of car, cost of the car, how long you finance it for, and how soon you can trade it in all work hand-in-hand. If you spend less, or finance the car for a shorter period of time, you can trade it in sooner and be under warranty for more of the time you’re driving. But, it will likely mean you have to compromise on the car you can drive or payment you can afford.
Metro Credit Union | Best Car Rates in Omaha
Our goal is to help you get the best deal possible, whether you finance with us or not! We'll use our resources to determine if you're paying a fair price for a new or used vehicle, whether you're getting the maximum out of your trade, and determine if
your loan rate is competitive.
All of this at no charge, with no sales pressure. It just makes sense to start your car buying experience with someone you trust, your credit union!
Plus, we offer great deals on extended warranties & GAP insurance.
Learn about things to consider when buying a used or new car.