If you purchased a car with regular financing and a low down payment, it is likely you owe more than the car is worth. This is called being upside down in your car loan. To trade for another car may require a significant out-of-pocket cash payment. Trading into a lease may be a way to get into a new car for a lower up-front cost.
Effects of Upside-Down
Trading a car with an upside-down financing situation has mostly negative consequences. The negative equity has to go somewhere. If you pay the negative equity in cash, the new car starts with a high loan to value since your cash went toward the old lease. The new car will again be quickly upside-down. If the negative equity is rolled into a new loan, the upside-down level will start out large and increase from there. Rolling negative equity into a new car loan probably means you will not be able to trade in the next car until the loan is nearly paid off.
Lease Away Negative Equity
The big advantage of trading to a lease is the ability to wipe out the negative equity in a shorter time. If the new car is on a 24-, 30- or 36-month lease, when the lease ends, you can go lease or buy another new car without having the negative equity of an upside-down car loan hanging over you.
Lower Upfront Lease Costs
A lease may also allow you to roll more negative equity into the new contract when compared with a car loan. Buying a new car with conventional financing requires you to pay sales tax on the purchase. If the leasing company is willing to finance the same amount as with car loan financing, the amount not paid in sales tax can absorb some negative equity into the new contract. Sales tax on a lease is paid on the monthly payments.
Effects on Payment
The negative equity on an upside-down trade-in goes into the lease payment. For example, if the amount of negative equity is $3,000 and the lease term is 30 months, the new payment will be $100 higher than leasing the car without the trade. The extra $100 will also accrue some interest and sales tax. You must decide whether it makes more sense for you to pay the $3,000 at the time of purchase or spread it over the term of the lease.