Many consumers who trade in old cars for new end up rolling over unpaid balances into their new loans. For serial offenders, the result can be disastrous.

IN DECEMBER 2001, Stuart Smith found he couldn't resist automakers' zero-percent financing deals any longer. He negotiated a good price on a Toyota Celica, got financing from the dealer, grabbed the keys and happily sped out of the dealer's lot. But eight months later Smith, 35 years old, decided the sporty sedan wasn't the right car for him. So he went back to the same dealership to trade it in for a Toyota Matrix.

There was a problem: The Novato, Calif. resident was "upside down" by $2,000. In other words, Smith owed more money on his loan than the car was worth. Not to worry, the salesman said. He told Smith he could add the balance of the note onto his new loan.

A scant 18 months later, Smith again started yearning for that new car smell. But this time he found, to his horror, that he was upside down by $6,500 -- quite a sum to add onto a new loan. Smith smartly decided to pay off the existing loan before buying a new vehicle. Now, he plans to be driving his Acura RSX long after the payments have ended.

Smith's story isn't unusual. Nationwide, 27% of all consumers trading in a vehicle are upside down on the existing loan, according to Edmunds.com, with an average of $3,800 in negative equity. (Negative equity is the difference between the balance on the loan and the vehicle's value on the open market.) In California, 38% of people trading in a vehicle still owe an average of $4,700 on their existing loans. Like Smith, most drivers simply add that debt to the balance on the new loan or lease.

This can be highly dangerous, warn auto and financial experts. By wrapping negative equity into a new loan, consumers could be starting a cycle that's difficult to break. Do it a second or third time, and they could find themselves trapped underwater, faced with the prospect of driving a vehicle long past its warranty has expired or shelling out thousands to pay off the loan. "A car owner could wake up with a vehicle that's worth $10,000 but owe $30,000," says Bob Kurilko, vice president of marketing and industry communications at Edmunds.com.

The easiest way to avoid this situation is to understand how the problem starts.

The Lowdown
Vehicles are more expensive than ever, with the average new car retailing for more than $30,000, according to Edmunds.com. Since many Americans don't have that kind of cash sitting in their bank accounts or can't afford conventional four-year loans on such expensive cars, finance companies have begun extending loan durations to cut the monthly payments. GM and Ford, for example, offered six-year loans in September on their 2004 models, says Rob Gentile, associate director of auto price services for Consumer Reports. The problems with longer loans are twofold, Gentile says: Consumers end up paying more interest over time, and the vehicles tend to depreciate faster than borrowers can repay the loans.

All those manufacturer incentives, such as the zero-percent financing and cash rebates, are also contributing to the problem. How? They make cars and trucks depreciate even faster as incentives water down a brand's prestige, says Edmunds.com's Kurilko. Rental companies also tend to buy cars with heavy incentives in bulk and then turn around and sell them in six months or a year, flooding the used-car market and depressing prices.

Moreover, many consumers are so focused on monthly payments and financing deals that they neglect to negotiate on price. Some 38% of consumers didn't haggle at all when buying their last vehicle, according to an April 2003 Consumer Reports survey. "A lot of times, consumers make the mistake of telling (a salesperson) what monthly payment he wants, and the (salesperson) sells a car for over list (price) by stretching out the term on the loan," says Chris Koster, a finance manager at a Florida car dealership.

Avoiding the Trap
Take Stuart Smith's advice: Avoid this situation if you can. The first step is to make sure you don't buy more car than you can afford. Edmunds.com recommends buyers make a 5% to 10% down payment, and suggests that total car expenses, including insurance and maintenance, should be less than 20% of take-home pay.

Next, you need to do a little homework. When narrowing down your wish list for a new vehicle, search for one that holds its value and is considered reliable. You can compare amortization schedules on sites like Kelley Blue Book and Edmunds.com and reliability on ConsumerReports.org.

Next, figure out how long it would take you to break even on your purchase, based on how quickly your car will depreciate and the terms of your financing -- and don't trade it in one day sooner. Many people don't realize that a car loses 15% to 25% of its value the moment it's driven off the lot. It typically takes three years of payments on a foreign car and four years on an American model before the driver is "right-side up," says Edmunds.com's Kurilko. You can expect it to take a lot longer if your loan stretches out to six or seven years and you've wrapped negative equity into the note. If you decide to go this route, you should purchase a vehicle with a long warranty and drive it until the loan is paid off.

Some Added Protection
Even if you plan on driving your car for years to come, you could still end up owing money on your loan. Nearly 10% of all vehicles are involved in an accident at some point. If it happens to you in the early years of a loan or lease, you could be in trouble. If your car is totaled, your insurance company will reimburse you only for your car's residual value. Chances are, that's going to be a lot less than the balance on the loan.

The good news? When you insure a car, you can buy so-called gap insurance to cover the difference in such a situation -- often for around $500, advises Edmunds.com's Kurilko.

Finally, we understand that many people believe a car is an extension of their personality. But we would urge you to remember that a monthly payment shouldn't keep you from achieving your other financial goals, such as saving for retirement. If you fail on that front, you need to consider just what type of message you're sending the neighbors.