Finance: Consumers taking on negative equity to buy new cars

While working out the gym this week, I heard several ads on the local radio station urging consumers to take on more debt. One was for an airline promoting that you can now get a loan to pay for your vacation trip – this is not a wise idea.

This was followed by an ad for a local car dealer encouraging you to trade in your car, even if you owe more on a car loan than the car is worth. In the hyper rapid voice over at the end of the ad they mention this means taking on negative equity. In other words, going further into debt!

You take out a loan to buy a car for $25,000. Three years later the car is worth $15,000 but you still owe $20,000 on the car. You trade it in to buy a newer $30,000 car and roll over the $15,000 value of the used car to pay off $15,000 of the $20,000 remaining. Since you come up $5,000 short on the old car loan, you roll this over to the new car loan. Congratulations, you now owe $35,000 on your $30,000 car. That’s called negative equity.

When I heard the ad, I could not believe consumers could be this naive.

Borrowers are responsible for paying their remaining debt even after they get rid of the vehicle tied to it. When subsequently buying another car, they can roll this old debt into a new loan. The lender that originates the new loan typically pays off the old lender, and the consumer then owes the balance from both cars to the new lender. The transactions are often encouraged by dealerships, which now make more money on arranging financing than on selling cars.

More: A $45,000 loan for a $27,000 Ride: More Borrowers are Going Underwater on Car Loans

The lead anecdote in this story replaced his car 4 times in two years, each time taking out a larger loan (saying he had to do this due such things as a divorce, mechanical problems, and then wanting a larger vehicle). The article says 1/3d of those trading in a car took on negative equity loans.

As a general rule, its better to borrow money for items that deliver long term value. For example, home prices appreciate over time because multiple industries have persuaded government for police that make this happen. Taking out a loan for a high level education and degree may make sense for jobs that generate future high incomes, particularly professional degrees in health care, engineering, business and potentially law. It does not make sense to take out a loan so that you get a minimum wage job without benefits at Great Clips.

How can you buy “stuff” if you do not take out a loan? You work hard, avoid spending like crazy including buying less than you can afford at the time, and save your money.

Wealth = Assets – Debt

Many people prefer to look wealthy and do so by spending and borrowing, under the misconception that

Wealth = Assets + Debt

During The Great Recession, the local paper ran a story about the business of automotive repossessions (when debts were not paid). All of those interviewed had similar stories – the typical auto repossession was at a large, new house, with two newer SUVs, a $35,000 boat and an RV (trailer or mobile home) – all paid for using debt. These people all looked wealthy to the outside world but only because they confused the definition of wealth.