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What It Looks Like When Your Car is Underwater

Kathleen Keest over at Credit Slips gives the most concise explanation yet of why a worrisome percentage of car owners are underwater on their auto loans – and how that big problem affecting the economy is being overlooked.

Lots of people think that when they trade in their old car to buy a new one, that they’ve somehow wiped away any remaining debt on the old car. Not so, says Keest. She outlines a practice she calls “Drive One, Pay for Two,” which occurs when dealers bury the cost of refinancing the old car into the new loan.

From Keest:

Here’s how that works: The value of the trade-in is $8000; balance on the loan for that trade-in is $10,000. That leaves a $2000 deficit that either a) the dealer eats (unlikely), or b) you have to cover with an extra cash down payment as well as the trade, or c) gets rolled into the new car loan. The last option means that you are essentially refinancing the remaining debt on the car you just sold back to the dealer, along with the price of the new car and whatever add-ons get added on back in the F&I office.

A lot of prospective buyers might decide to wait on that new purchase if they understood that their new car loan would include left-over balance on the car they don’t own anymore. So a lot of dealers used to (still??) fudge the numbers on the loan papers so the old loan pay-off disappeared. (Don’t even ask about the Truth in Lending rules and issues.)

As cars get more expensive, and loan terms get longer (to keep those monthly payments affordable!) that increases the odds of negative equity caused by left-over debt from the trade-in. In theory, the lenders financing those loans would want to know if the car was going to be underwater due to negative equity before it even drove off the lot. But in practice – just as with the mortgage industry, the only thing worse for your monthly numbers than a weak(er) loan was no loan at all.

It only gets worse, as Keest explains:

Estimates seem to be that about 25% of car loans are under water, and an April, 2008 BenchMark consulting report put the average amount in glub-glub territory on a new car loan at $4250. Last year Nobel economist Nouriel Roubini worried about the potential losses in the auto loan sector because of reckless lending and significant negative equity. But here’s the thing –Roubini’s (borrowed) explanation just talked about no downpayments and the fru-fru add-ons. Sounds like “Drive One, Pay for Two” wasn’t even on his radar screen. I wonder who else’s it isn’t on.

Keest is senior policy counsel at the Center for Responsible Lending and a new guest blogger at the excellent Credit Slips blog. If you want to understand the credit crunch and the mess we’re in, it’s well worth your time to check out her work.

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