Is leasing a good way to cover negative equity from a car loan?

Car leasing is often used as a way of “hiding” or “covering up” or “rolling” negative equity from a car loan.

When trading a car with an “upside down” auto loan, the amount of the loan not covered by the value of the car is called negative equity. Somehow, that amount has to be paid — either with a cash down payment on the new car, or by “rolling” it into a new loan or lease.

Adding negative equity to a new loan or lease makes for higher monthly payments and (usually) creates a new “upside down” situation, which makes it normally not a smart thing to do.

However, there may be circumstances that make hiding negative equity into a new loan or lease beneficial.

So, the question becomes, is it better to trade and lease a new car, or trade and buy with a new loan — when you are upside down on your old loan?

In many situations, leasing is the better option.

Why a lease? Why not another loan?

Because leasing produces a much smaller payment than buying with a new loan, even after adding significant negative equity.

Let’s take a look at a representative example:

Assume that we’re trading a car worth $8000 for a new car priced at $25,000. However, we’re “upside down” on our old car loan and still owe $10,000, which means we owe $2000 more (negative equity) than the trade value of our old car. What to do?

Let’s take a look at our options:

Option 1. Get a 36 month loan for $25,000 for the new car, let the dealer pay off our old $10,000 loan, he gives us $8000 credit toward the price of the new car, and we pay him the $2000 difference in cash as a down payment. The monthly loan payment (assuming a 4% APR interest rate) would be $738/month.

Option 2. Same as Option 1 except we let dealer “roll” the $2000 negative equity into the new loan, making our loan balance $27,000. The monthly payment in this case would be $797/month.

Option 3. Lease the new car, with a lease price of $25,000, for 36 months with a residual value of $12,500 and 4.0% interest rate, and pay the negative equity of $2000 as a cash down payment. The monthly lease payment would be $410/month.

Option 4. Same as Option 3, except we let dealer “roll” the $2000 negative equity into the new lease. In this case, the monthly payment would be $469/month.

Notice that the amount of increase to the monthly payment is the same — $59 — for both the loan and for the lease. However, the total payment amount is much less for the lease.

Possible Problems

In our examples above, we “only” had $2000 in negative trade equity, which is relatively small when compared to the $25,000 price of our new car.  In fact, the negative equity is less than 10% of the new car financed price. It’s usually not difficult for a dealer to get a loan or lease approved with such a small amount of negative equity to “cover”.

However, problems may arise when the ratio is greater than 10%. This can be caused when the amount of negative equity is too great, or the price of the new vehicle is too low — or both.

For example, if there was $5000 negative trade equity and we were attempting to purchase or lease a $15,000 car, a dealer would almost certainly find it impossible to get such a deal approved. Banks and finance companies would not want to finance $20,000 ($15,000 + $5000) for car that is only worth $15,000. The risk is simply too high that they would lose money if the customer stopped paying on his loan or lease. If the vehicle was destroyed in an accident, insurance would only pay replacement value, not the full amount of the loan or lease. This would likely create a large deficit for which the customer would be responsible.

In this situation our options are limited. In order to go through with this deal and get it approved, we would have to cover some or all of the $5000 negative equity in cash, as a down payment, regardless of whether we buy or lease.

Conclusions

If you want a new car but still have an outstanding balance on your old car that exceeds the trade value of that car, your dealer might be able to cover the difference (negative equity) in your new loan or lease — as long as the amount is not too great relative to the financed cost of the new vehicle.

Leasing provides the lowest possible monthly payments even with negative equity added. However, before making such a decision, make sure that leasing is right for you. Read our article, Who Should Lease, for more details.

Leasing as a technique for “hiding” or “covering” negative equity can work great in the right situations, but only if the lease is not ended early.