If You Owe Less Than the Car Is Worth
If the balance on your existing loan is less than what the dealership is offering you for your trade-in, the difference goes toward your new car. For example, if you still owe $5,000 on your old car and the dealer is willing to give you $7,000 for it, the dealer pays off your loan to release the lien and to get the title from the original lender. The dealer now owns your car and he still owes you $2,000. If the new car's sticker price is $30,000, you get it for $28,000 -- $30,000 less the $2,000.
If Your Loan is Upside Down
If your outstanding loan balance is more than what the dealer is willing to give you for your old car, your vehicle is said to be upside down or under water. You can still trade it in, but the deficit must be accounted for somehow. If the dealer is willing to give you $7,000 for the car but you owe $9,000, you must come up with an extra $2,000 because the original lender isn't going to release the lien and title until it receives all the money you owe. Kelley Blue Book says this happens to roughly half of all consumers who want to trade in their old, still-financed vehicles for new ones.
Effect on the New Loan
If your trade-in is upside down, the dealer will still pay off your existing loan. If he offers $7,000 for the trade-in and you owe $9,000, you can either give the original lender an additional $2,000 to clear the loan or you can finance $32,000 for the new car instead of the $30,000 sticker price. The first $30,000 buys your new wheels and the extra $2,000 clears the lien against your trade-in. You're effectively paying for two cars in one loan. You might have to stretch the new loan out for a longer term to keep the payments reasonable because you're borrowing more. Also, the new lender must feel comfortable that it can sell the new car for a sufficient price to cover the full amount of your loan if you default and it must repossess the vehicle.
Effect of Incentives
Dealers sometimes get creative rather than lose sales due to a buyer's negative equity on his car. For example, if the dealer decides to throw in a $2,000 incentive because you're buying a brand new vehicle, your negative balance goes away and you won't have to finance anything extra. A similar tactic might involve the dealer dropping the price on the new vehicle to $28,000 so you can still buy it with a $30,000 loan, rolling in the $2,000 you still owe on the old car.