Dealing with Negative Equity
This article has been written with source information from The National RV Dealers Association Dealer Information Fact Sheet, December 1998; Regulation Z Commentary; and from recent court activity in the state of California.
Edmunds.Com reports that the average person has $2,200 negative equity in their current vehicle. How to deal with this problem and keep regulators, customers, and lenders happy is an ongoing challenge.
A Working Definition
Negative Trade Equity refers to a situation in which the allowance given for a trade-in vehicle is exceeded by the amount required to release the liens against an owned trade-in vehicle or to pay off the lease of a leased trade-in vehicle. In Finance & Insurance (F&I) language, negative trade equity means the vehicle customer is “upside down.”
A Change in Interpretation
Regulation Z governs consumer credit sales under the federal Truth-in-Lending Act. The Federal Reserve Board Staff Commentary to Regulation Z regarding disclosure of “negative trade equity” in consumer credit sale contracts was revised October 1, 1998. The revision reads:
“In a credit sale, the ‘down payment’ may only be used to reduce the cash price. For example, when the existing lien on trade-in exceeds the value of the [vehicle], creditors must disclose a zero on the down payment rather than a negative number. To illustrate, assume a consumer owes $10,000 on an existing loan and that the trade-in value is only $8,000, leaving a $2,000 deficit. The creditor should disclose a down payment of $0, not $2,000. However, ‘negative trade equity’ may still be financed as part of a credit sale.”
The revised commentary to Regulation Z specifically provides that “[if] the credit sale involves a trade-in and an existing lien on that [vehicle] exceeds the value of the trade-in amount, the creditor may disclose [in the itemization of the amount financed] the consumer’s trade-in value, the creditor’s payoff of the existing lien, and the resulting additional amount financed.”
Handling Negative Trade Equity In A Credit Sale Transaction
If customer owns a vehicle or has a leased vehicle with negative equity and wants to dispose of that vehicle as part of the credit sale transaction, two possible solutions exist:
(1) Include the Negative Trade Equity as Part of the Amount Financed Under the Credit Sale Contract. Where the customer can qualify, financing the negative trade equity as part of the new purchase transaction is the legitimate way to handle the deal. If the customer cannot qualify for the financing of both the new vehicle purchase and the negative equity of the trade-in vehicle, the deal should not be done in the first place (unless the customer has sufficient cash to apply to the transaction to pay off or reduce the lien which is discussed as the second solution).
The best way to deal with negative trade equity is up front and in the open. This greatly reduces potential problems for the customer and/or the state motor vehicle regulators, and the sales finance company that buys the contract.
(2) Customer Pays Off or Reduces Prior Debt. If the customer uses existing funds to pay off the prior debt, the negative trade equity is eliminated. The trade-in vehicle can then be treated as having positive trade equity equal to the amount of the trade-in allowance.
A variation of this solution is for the customer to make a large enough down payment to reduce the prior debt to an amount that is equal to or less than the trade-in allowance, thereby eliminating the negative trade equity. However, if the contract documents are written with the assumption that the customer is paying off or paying down the trade-in lien directly to the previous lender, the customer’s obligation to do so should be clearly noted on the Motor Vehicle Purchase Contract.
Lenders should have vehicle contract forms that comply with the new requirements. Check to see if the Itemization of Amount Financed includes the line “Prior Credit or Lease” balance (or similar wording) in the column that itemizes the amount financed.
The Perils of “Creative Financing”
Negative trade equity can also be eliminated by increasing the trade-in allowance to equal or exceed the amount of the lien payoff. When the trade-in allowance is increased, the cash price is also increased by an equivalent amount so that the dealer can retain the same profit as before the allowance increase. This is sometimes called “creative financing.” It is not recommended for several reasons.
First, raising the trade-in allowance above the actual cash value of the trade-in will result in a financial loss to the dealer when the transaction must be rescinded. If the deal is unwound and the dealer is unable to return the trade-in, the dealer must pay the customer the inflated trade-in allowance.
Second, if there is a “lemon law” governing return of the vehicle, the inflated price will be used to establish the basis of the refund to the customer. While it is true that the manufacturer would make the refund, it is not in a dealer’s best interest to put their manufacturer in a difficult position. It is even possible that a manufacturer might attempt to hold a dealer responsible for the difference between MSRP and the inflated price.
Third, when the trade-in allowance is increased, the dealer can retain the original profit in the deal only by also increasing the cash price of the purchased vehicle. Where a purchase contract containing the original cash price his already been signed, increasing the cash price on a second contract may result in allegations of “bushing,” particularly if the customer does not fully understand (or later claims not to have understood) the reason for the increase.
Lender Policy
For the most part, lenders will not fund a contract that shows negative equity on the trade. This policy needs to be reevaluated. Dealerships are being dragged into court and found guilty of violations of Regulation Z. The courts are taking a dim view of increasing a customer’s sales tax and licensing fee liability, along with the increased interest on the inflated taxes. In short, dealerships are suffering for structuring deals so that lenders will fund them.
Many dealerships now require that customers sign a disclosure acknowledging the deal structure, inflated trade allowance, and inflated sales price, along with the sales tax, license fee, and interest. The disclosure specifies how the deal is structured and why. Only time will show if these measures are enough to protect the dealership.
Finding Equity
Lack of down payment and length of loans are the primary drivers for the negative equity that presents at just about every turn and in most deals. A consensus on how to treat negative trade equity is long overdue. Consumers need transportation, dealerships need customers, lenders need to fund loans, and we all need to stay out of the courtroom.
World of Special Finance Magazine, February 2004, p. 16 & 35