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Consumer Credit: What Is Reverse Equity?

If you have gone to the dealership to trade in your current vehicle on a new one you may have heard the term reverse equity. This is not a pleasant situation to be in and will often result in the sales person asking for a larger down payment than what you had previously thought. What is reverse equity and why is it important for consumers to understand how it works? It impacts many buying decisions and while it is normally relegated to the auto industry it has become more important to homeowners during the housing crisis.

Reverse equity is a more technical term referring to the situation of when an asset is worth less than what is currently owed. For a long time this is been applicable to automobiles where a consumer finances a new car purchase for six years but then looks to trad it in after only a few years of ownership. It is common knowledge that new vehicles depreciate rapidly the moment they're driven off the car lot. If for example a consumer purchases a $28,000 vehicle and finances all of it at 6% interest for seven years it will make for smaller monthly payments but will cost a little over $34,000 when the loan is paid in full. If they look to trade in the vehicle after two years they will still owe almost $21,000 but it is likely that the vehicle will be worth $18,000 or less for a trade-in value to the dealer. At this point they will have reverse equity on their trade in which is commonly referred to as being "upside down" or "underwater". Essentially the consumer owes more than the vehicle is worth so in order to discharge the loan it will cost an additional $3,000 which will be added to the down payment to purchase the new vehicle. When you have this discussion with the salesperson there is very little that can be done because the blue book trade-in value of the vehicle as well is how much is currently owed on the outstanding auto loan is very black and white. This is why it is often recommended to purchase your vehicle and keep it for a decade or more or to put 30% or more down during the initial purchase.

During the recent housing crisis a new situation arose where many homeowners experienced a very similar situation to that of new automobile purchasers. Never before in recent history had housing prices dropped so dramatically in such a short period of time. In many markets throughout the country housing prices decreased by 50% or more leaving many homeowners upside down on their mortgages. In these situations, homeowners who purchased $300,000 homes were now looking at home values of $150,000 or less then they would have reverse equity in the six digits. The question many homeowners in this situation asked themselves is how much money do they want to pay on a home that may never increase in value to level of which they paid? Some homeowners chose to walk away from their existing financial obligation and stop making monthly payments while others became more creative and decided to either rent the home out and move into a much less expensive residence or conduct seller financing with prospective buyers.

When a consumer finances the purchase of an asset and that asset depreciates in value faster than the loan is paid off it results in reverse equity. This doesn't apply to most purchases because very few individuals are purchasing new consumer products and then trying to sell them a few months later. Reverse equity normally applies to automobile purchases which are financed over a long period on vehicles which depreciate rapidly. Periodically the situation also applies to homeowners during times in history where home values depreciate rapidly. Understanding reverse equity and how it affects you financially will help you make more informed decisions when it comes to financing and purchasing a new vehicle.