How Does it Work When You Trade in a Car?

Trading in a car is simple, but you easily can be taken advantage of if you do not arm yourself with a bit of knowledge beforehand.

Finding Trade-in Value of Your Vehicle

The first step in trading in your car should be a search on the internet or, if you are old school, a trip to the library. The search is so that you can arm yourself with an approximate value of your vehicle before you go to a dealership. The two most reliable sites to visit are Kelley Blue Book (kbb.com) and the National Automobile Dealers Association (nadaguides.com). Both companies publish book versions of their value charts for those of us who prefer something we can put our hands on.

Vehicle Condition:  Being Honest with Yourself

The values are based on the condition of the car, so you will need to be honest with yourself about your car’s condition. If it has a couple of small dings where a shopping cart hit it, you may claim good or better condition. If it has a dent the size of a basketball, you cannot. Seem silly to say that? There are people who are attached to their car and assume it is a great specimen, when in fact it has in excess of 200,000 miles, leaks like a sieve, and only starts if you hold your tongue on the right side of your mouth while standing on your head when you turn the key. These people are very surprised when a dealership will only offer salvage value for the vehicle.

Sticking to Your (Price) Guns

Now, once you have a value in mind, it is time to go shopping. Granted, even if you carry a copy of NADA Guides into the showroom with you, the salesperson is going to try to lowball you. Haggling is great fun to some, but a nightmare to others. Stick to your guns as much as possible, give a little if need be, but be prepared to walk out if the dealership does not come close to what you want.

How Trade Equity Impacts Your Purchase

Once you have agreed to a trade-in value, the loan process begins. If you do not have a current loan, it is simple. The agreed upon value (trade equity) is deducted from the agreed selling price, then you either pay or finance the balance. If you have an existing loan, there are two scenarios. In the first, the trade-in value is greater than your balance, so the difference between your agreed trade-in value and the loan is deducted from the sale price. In the second, you owe more than the vehicle is worth. In that case, the trade-in value is deducted from your loan balance. Any balance that is still remaining is added to the sale price of your next car and you must either pay for the total of the two or finance that total.

Issues with Loan-to-Value Ratio (LTV)

If you have a loan balance that must be carried over to the new car, you may find it difficult to finance the new vehicle because of the negative equity created. One of the most weighted aspects of a vehicle loan is its loan-to-value (LTV) ratio. Major lenders will not approve a loan that exceeds 115 percent of the value of a vehicle. You can learn more about how LTV works here.

Fortunately, there are loan sources other than major banks. Credit unions may allow you to carry a higher LTV. Even if a credit union denies your loan, do not despair. There are many online specialty lenders who look more at your personal situation than at the LTV of a vehicle.

How Long Should You Finance Your Next Car?

How Long Should a Car Loan BeThere is no hard and fast answer to how long you car loan should be. There are several factors to consider, the main one being what you can afford without destroying your budget. Here are a few key points that may help you decide the ideal car loan length for your situation.

Payment vs. Total Price

When you look at a car, the first thing a salesperson will ask is ”how much of a payment can you afford?” That question is meant to get you to focus on monthly payments instead of the total purchase price. It also helps a salesperson steer you toward a longer loan term for a more expensive vehicle. The thinking is that as long as the monthly payment meets your needs, you may buy a more expensive vehicle, adding to the dealerships profit margin and the salesperson’s commission. As the buyer you need to focus on the total purchase price in order to avoid paying an excessive amount of interest over the life of a loan.

Higher Interest Rates

The longer your loan term is, the higher your interest rate is going to be. In some cases the rate can double just by adding 12 months to the loan term. Take this example for instance. The national average APR for a 60 month note was 2.69 percent in early 2013. All factors being even, extending that same loan to 72 months brought the APR to 4.9 percent. On a loan of $25,000 for a new vehicle, you would pay an extra $2,158.57 in interest and the monthly payment was only $44 cheaper.

Negative Equity

Everyone knows that your car will lose value immediately after purchased and will continue to do so for at least three years. You will be upside-down on the loan during that period, there is no way to avoid it. If you have a loan that lasts longer than 60 months, the added interest and finance charges will cause you to remain upside-down even longer. Depending on how quickly the vehicle depreciates, you may have negative equity in it for as long as five years.

With negative equity comes the harsh reality of not being able to recoup the balance of your loan when you trade the vehicle in. So, if you want another new car before this one is paid off, you will be forced to finance the remaining balance of the original loan as part of your new loan. By doing that, you guarantee that you will have negative equity in the new car for an extended period of time. Additionally, if the balance on the original loan is too high, you may not be able to get approved for another loan until the balance is paid down.

In my opinion, you should never finance a new vehicle for more than 60 months or a used vehicle for more than 48 months. If you opt for a loan of this length, coupled with a reasonable car payment amounting to no more than 10% of your gross monthly income, you will be in a good position to finance your next car.