Is It a Good Idea to Trade in Your Car Before It Is Paid Off?
You are nearing the end of your car loan, and you’re wondering if you should trade in your vehicle for a new one before the loan is paid off. Should you wait until you have done so, or is it a good idea to go ahead and trade it in for a new car whenever you find a vehicle that you like?
As with most large financial decisions in life, the answer is complicated—but we’re here to help make it easier.
A Car Is a Depreciating Asset
Before you decide whether or not to trade in your vehicle, you should understand that it is a depreciating asset which means that, unlike a house or a stock, it only decreases in value the longer you own it.
According to data from Carfax, a car depreciates about 10% of its value in the first month, 20% in the first year, and about 10% more of its value each year after that. That means your pristine $30,000 vehicle purchased in June will be worth about $27,000 in July, and $24,000 come next June.
If you have a loan on your vehicle and your car has decreased in value, you may find yourself in a situation in which you owe more on the car loan than the car is worth at any given point. If you put less than 20% down on your vehicle, this is very likely to happen to you within the first year. This will put you in a position of having negative equity, or owe more on your loan than you have in equity, which is equal to the value of your asset (in this case, your car).
If you trade in your vehicle when you have negative equity, this will put you in a position where the collateral you used to secure your loan—your car—is no longer in your possession. This will mean that you will owe the full remaining value of your loan as soon as you trade in your vehicle for a new one.
If you are not able to pay off the remainder of this loan, it will end up getting added to the amount of the new loan on your new vehicle. This will either make your new loan longer or your payments larger than they would have been if you had waited until you paid off your vehicle before trading it in for a new one.
When Is It a Good Idea to Trade In?
When you own a gas guzzler. If you own a vehicle that requires a lot of fuel, you could save a lot of money in the long-run by trading it in for a car that gets better gas mileage, especially if you drive a lot as a part of your regular routine. Make sure that you crunch the numbers though — If you pick a pricier car, you might not save money even if it has better fuel efficiency.
When the dealer credit is actually a good idea. If you only owe $3,000 on your loan and your dealer offers a $2,000 sign-over bonus, it may actually be a good financial move to trade in your new vehicle rather than paying off the remaining $3,000 over the course of several months.
When You Should Wait to Trade In
It is best not to trade in your vehicle when you purchased it very recently. As soon as you drive a new vehicle off the lot, it loses around 10 percent of its value and up to 20 percent of its value within the first year! If you purchased a new, not used, vehicle within the last year and are thinking of trading it in, just don’t. Whatever exciting deal or sweet ride you recently encountered can wait. It’s not worth wrecking your financial future for a newer set of wheels.
When you have prepayment penalties. When a lender agrees to a car loan, they are counting on earning interest off of you for a set amount of time. When you pay off a loan early, you are depriving the lender of this income—and because of this, you will likely pay a prepayment penalty in most cases if you pay off the loan early.
When time is on your side. If you own a newer car, you can always trade it in later or sell it to another private party, which would generally mean you would make more money off of the transaction.
If You Do Decide to Trade In Your Vehicle
Make sure you understand and get in writing, exactly what you are going to be getting from the dealership when you purchase your new car. Make sure to ask, and pay special attention to, how your new loan will treat negative equity. It will definitely be easy to find a dealer who will finance your purchase, but the more important question will be whether or not it is truly worth it for you.