How Does Negative Equity Affect a Car Lease?
What is negative equity anyway?
Negative equity exists when a car loan or lease’s outstanding balance is greater than the current value of the car. It’s sometimes called being “upside down” or “under water.”
Negative equity can affect a car lease in several ways.
If you are looking to lease a new car and you have an existing loan on a current vehicle that you plan to trade, having negative equity means you have no trade value in your current — nothing to use as a down payment on the new lease. In fact, in order to trade, the negative loan balance, after trade value, must somehow be paid. Although your dealer will pay off the entire balance, he’ll have to decide how to handle the negative equity — the difference between the loan balance and the credit he allows for your trade vehicle.
If the difference is relatively small, he and his lease finance company may be able to “roll” the amount into the cost of the new lease. Otherwise, you’ll be required to pay all or most of the difference in cash as part of your “cash due at lease inception.” This amount would be in addition to your first month’s payment and other taxes and fees. Having a large amount of negative equity can easily make a new lease deal impractical and unaffordable.
Another way in which negative equity affects a car lease is if you are already in a lease and want to end it before the normal end date. Most leases are “upside down” for nearly the entire term of the lease. That is to say, the amount remaining on the lease balance is nearly always higher than the current value of the vehicle. This can make an early termination very expensive, and possibly not practical.
There are factors that make it more likely that you’ll be upside down in a lease. First, a lease balance can begin too high if the price of the vehicle was not negotiated and not less than MSRP. Second, not making a down payment (cap cost reduction) or not having a valuable trade vehicle at the time of lease initiation can make for a high lease balance. Third, leasing a vehicle that depreciates rapidly or having a high finance rate (money factor) can also contribute.
In short, you’ll always be in a negative equity situation during a lease if your monthly payments don’t pay down the lease balance faster than the rate at which the vehicle depreciates.
The final way in which negative equity can affect a car lease is at lease-end. All lease contracts have a lease-end residual value, which is also typically the purchase option price. If the vehicle’s market value at the end of your lease is less than the contract purchase price, there is negative equity. In this case, it would be better to return the vehicle to the lease company and let them take the financial hit. On the other hand, if the vehicle is worth more than the contract purchase price, positive equity exists and it might be advisable to purchase or trade the vehicle to claim that value for yourself rather than return the vehicle and give the equity away to the lease finance company.