In the aftermath of the Great Recession, you probably heard about plenty of people whose homes were underwater. Maybe you were one of them.
Now, the analysts at Edmunds say plenty of cars are underwater, too. How did this happen?
When we say that something is "underwater", we mean that (a) it was purchased on credit and (b) it's now worth less than the total of the loan used to buy it. Case in point: following the real estate bubble that burst around 2007, it was common for people to owe significantly more on their homes than those homes could fetch on the market.
Believe it or not, the same principle can apply to cars, though it works a bit differently.
Home prices can fluctuate pretty dramatically, depending on location. If you were to look at 2,500 square-foot houses in Dallas, San Francisco, and Boston, chances are, they'd have very different prices due to demand, taxes, and many factors. Demand for homes in certain markets can drive prices dizzyingly high, then let them plummet back to earth. (Case in point: Las Vegas after the Great Recession.)
Car prices don't change as much as real estate prices. Cars are made by automakers who provide suggested retail prices. Dealerships can wheel and deal with shoppers a bit, but consumers aren't likely to shell out less than what the dealer paid for it.
The problem with cars usually comes down to financing, which can affect a vehicle's equity in at least two ways:
1. An owner may stretch herself too thin. Cars are very, very pricey. The average new car costs around $34,000, which is more than most shoppers can truly afford.
If you're in that number, you may be tempted to shell out for a vehicle that's going to be a drain on your finances, until you're finally forced to sell it. Depending on the rate of depreciation and how well you've maintained the car, you might not be able to get enough from selling it or trading it in to cover what you owe in loans.
2. An owner may extend the loan for too long. This is a variation of item #1 above. You might look at a new car and tell yourself that you'll be able to pay for it, but only if you stretch out the loan to 60 or 72 months. As with a mortgage, however, most of your payments for the first couple of years will go toward the interest on that loan; they won't reduce the principal. If you choose to sell your car or trade it in during that time, you might discover that the principal hasn't really budged, meaning that you have little equity in the vehicle and still owe nearly the full cost.
Is this a big problem? Apparently it is. In fact, Edmunds says that roughly 32 percent of trade-ins for new cars recorded during the first nine months of 2016 were underwater. That's an all-time high. On average, those folks owed $4,832 more than their cars were worth at the time of their trade-ins.
And used-car shoppers aren't doing much better. In fact, Edmunds says that 25 percent of vehicles traded in for used cars during the first three quarters of 2016 were underwater, too. In fact, those owners had an average of $3,635 in negative equity in their trade-in vehicles.
This may explain why leasing is becoming a more popular option with consumers. Through October 31, some 33 percent of all new-car transactions were leases. Not only are lease payments cheaper than loan payments, but because leases don't involve equity in the same way as loans, there's less chance for consumers to find themselves underwater. As Edmunds analyst Ivan Drury explains:
"It’s curious to see just how many of today’s car shoppers are undeterred by how much they owe on their trade-ins. “With today’s strong economic conditions at their back, these shoppers are willing to absorb a significant financial hit to get into a newer vehicle. In fact, shoppers with this mindset may want to consider jumping on the leasing bandwagon. They can get into a new car with great technology every few years without having to worry about how much they still owe on their trade-in."
Do you prefer to buy or lease vehicles? Have you ever had to deal with the problem of being underwater on a car loan? Share your experiences in the comments below.