Capitalism has many benefits in a free society. It has inherent benefits
to those who are creative and willing to work hard. Nowhere else can such
a variety of people from many diverse backgrounds and countries succeed
by their own efforts. However, sometimes our creative efforts cause serious
problems. As a people, we have become enamored of things, possessions,
and goods. We want to own the biggest house, the biggest automobile and
other possessions without number. And for all the things we say we want
there are manufacturers ready and willing to provide them. In order to
be competitive these same manufacturers are always seeking better ways
to convince us that it is possible to own that Cadillac El Mundo Gordo
Magnifico SUV when realistically we can only afford the Ford Sub-Midsized
Ordinary Sedan. Desire for things, plus superb salesmanship overcomes
common sense and basic math. The result can be what the subject of this
article is all about.
Let's clear up a couple definitions.
Equity: The market value of a property (house or car or whatever) minus any mortgage
or money owing on the property.
Example # 1 Positive Equity: You have owned a house for thirteen years. Its market value is $400,000.
You owe the bank $225,000 over the next seventeen years. Your equity in
the house is $175,000. This is positive equity.
Example # 2 Negative Equity: You buy a house for $300,000. The housing market changes and the market
value drops to $200,000. You owe the bank $225,000. Your equity in the
house is $25,000. This is negative equity and sometimes referred to as
being "upside down". This is a very bad thing.
Negative Equity occurs frequently with automobile purchases. What do you
do if you've had the car two years and want to trade it in? The "upside
down" buyer frequently adds the amount on the trade-in onto the loan
for the new car. They also stretch out the loan to keep the payments low.
This is a losing proposition as the longer the loan, the longer it takes
to reach a point where they owe less than the vehicle's depreciating
value. It is a financial Catch-22.
How does this happen? It is a combination of things. In order to sell more
cars, manufacturers offer deep discounts on new cars. This has the effect
of depressing the value of cars, which coupled with five and six-year
loans means it's going to take much longer for car owners to achieve
a position of positive equity. (two to three years is not unusual)
It is a fact that the moment you drive your car away from the lot it is a
used car. If you are paying $45,000, the Kelly Blue Book value may be $40,000.
If you still owe $43,000, there's a $4000 difference. How do you protect
yourself if you have an accident? Now the vehicle owner has more problems.
Why is an auto gap insurance policy so important? Because standard comprehensive
and collision auto policies only cover your new car's "fair market
value". And that can be as little as 80% of what you paid for your
car, starting the minute you drive it off the lot. Look at Figure 1. The
areas shown in orange are the gap or the owner's position of negative
equity. This condition may exist for the first two or three years of ownership.
This means that if you're involved in an auto accident that leaves
your new car "totaled", you could end up paying off a loan on
a car that you can't drive. This is where gap insurance comes in.
A gap car insurance policy insures you for the difference between what
you owe on your car and what your insurance company says it's worth.
In some cases this insurance will be required as part of purchase or lease.
Gap insurance coverage would also become critical if your car is stolen.
Thieves prefer new cars and they seek out specific models, which usually
happen to be the most popular models of cars sold. (Honda Accord, Ford
Taurus - etc. etc.)
If your car is stolen, the insurance situation is the same as in the case
of an at-fault accident on your part: comprehensive insurance will cover
the value of the vehicle, but not necessarily the value of the loan that
you owe to the bank. You could be stuck paying thousands for a car that's
long gone. Add that to the truly disheartening feeling of having your
car stolen, and that makes for a really rough time.
Figure 1. An Auto Loan Negative Equity Example
As a Lemon Law firm, we see many situations of negative equity when a case
is being settled with an auto manufacturer. Often it is the first time
the owner discovers the reality of being upside down on their loan or
lease. It is always painful. We certainly could offer scads of advice
about this situation. The first piece of advice would be, never buy something
that is beyond your means. This advice will surely be ignored over and
over. The other thought, which isn't really advice is, if you get
caught in a situation where your negative equity is going to be expensive,
bite your lip and promise yourself you will never get in that sort of
situation again. It's bad for you and accepting these kinds of deals
only encourages manufacturers and their financial organizations to offer
these "good deals".