The average new car loan has a term of 68.48 months, according to the credit rating agency Experian – nearly six years of being married to your new ride. And that's just the average. Nowadays, one-fifth of all new car loans are 84 months or longer. So what happens if you've fallen out of love with your current vehicle before the loan is paid off? It might be no longer appropriate for a myriad of reasons. For example, the size of your family has changed. Or you've moved to a snowy climate and you're afraid to drive your Miata as a daily.
The good news is that you can definitely trade in a vehicle on which you're still making payments. However, the loan doesn't just vanish. If you owe more on your car than it's worth as a trade-in, that's called negative equity — sometimes referred to as being "upside down" on your loan.
One option is for car buyers to pay that difference in cash, although that might not be possible for cash-strapped consumers. Another, far more common option is for the dealership to bundle the negative equity from your old loan into the new loan for the car you're buying. That's called rolling over a loan, and we'll explain what's involved.
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Let's say you still owe $20,000 on the vehicle you're trading in, but the trade-in value is only $15,000. If you don't want to pay that difference, the dealership's finance department may be able to add that $5,000 shortfall to your new car loan. That said, there are limits to how much negative equity can be rolled over into a new car loan. Guidelines vary, but suffice it to say that a lender won't want to lend $50,000 toward the purchase of a brand-new $35,000 car. That's an instant, radical upside down situation that will sting the lender in the event that you stop making payments and the vehicle gets repossessed.
Rolling over an old car loan certainly isn't ideal. Continually doing so will keep car owners on a negative equity treadmill that results in higher monthly loan payments. Mistakes and bad decisions happen, but it's best to avoid continuing that pattern. Going forward, select a more modestly priced vehicle that you can afford to pay off in a reasonable period of time. If buying a vehicle involves a 96-month loan, you can't truly afford it, in spite of what the car salesman might say. In other words, don't be like this Ferrari owner who's upside down to the tune of $200,000.
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So far, we've painted a pretty negative picture of trading in a car with a loan remaining. However, if you made a large down payment when you purchased it, the loan term was short, or your vehicle holds its value well, you might have some positive equity in your trade. In other words, your trade-in could be worth more than the loan balance. In that case, the smart move is to have the dealership apply that equity toward your new vehicle as a down payment, or in addition to your already-planned down payment.
Finally, make sure your current lender doesn't charge a significant fee for ending your loan early. Called prepayment penalties, these fees are intended to compensate lenders for the profitable interest lost if a loan is paid off early. That's one of the reasons why car dealers don't want you to pay off your loan right away. Prepayment penalties vary or may not exist at all, so do your due diligence. If there's a significant penalty, it could be worth trying to live with your existing vehicle, if at all possible, until the loan is paid off.
Once you've decided to trade in a financed car, the car dealership buying your trade-in handles the paperwork. When you sign a few documents, the old loan's repayment and obtaining a clear title for your trade-in happen behind the scenes — and you drive off into the sunset, intoxicated by that new car smell.
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