Staring down a large car payment every month can be intimidating. If you’ve run into a financial emergency, or just want to save a little cash every month to put towards other expenses, you may be considering refinancing your auto loan.
Lenders aren't shy about calling and offering their services either, so you may have already spoken with a few people who promised to lower your monthly payment or help you pay your car off faster with a refinance.
With 95% of U.S. households owning a vehicle, and 85% depending on their vehicle to commute to work, there are a lot of people out there on the roads.
In fact, Americans took out more than $54.6 billion in new auto loans between July 2017 and July 2018, an increase of 7.3% from the year before, according to the Consumer Financial Protection Bureau.
Rising housing costs, rising gas prices, job loss, health problems, and more financial awareness may all factor into the decision to refinance a vehicle. But, before you move ahead in the process to change the terms of your auto loan, take a few minutes to learn the ins and outs, so you understand exactly what the process entails and whether or not this option would work well for your situation.
How does refinancing a car work?
In the simplest terms, refinancing a car loan means replacing the terms of your current auto loan with new terms, ideally at a lower interest rate.
Think of it like refinancing a home loan; a refinance uses one loan to pay off a new one. Most of the time a refinance is done with a new lender.
Typically, borrowers refinance to take advantage of a lower interest rate. A lower interest rate may be available due to market changes or changes in your personal finances, like if you have paid off a lot of debt or you have increased your income. Other common reasons to refinance include removing a borrower (or cosigner) from the loan or adjusting the length of the loan.
One of the most important things to understand is that refinancing an auto loan may not lower your monthly payments, in fact, your monthly payment could go up substantially.
Whether your loan goes up or down depends on what terms you change. Changing to a shorter repayment period could increase your monthly payments as you'll have fewer months to repay the total loan while decreasing your interest rates or extending the length of your loan will likely reduce the total monthly payment.
When should I refinance my car?
You should wait at least six months to refinance your auto loan.
There are a few reasons for this, but primarily, waiting to refinance looks better on your credit score, and makes it easier to get a good deal.
If you're paying off debt or increasing your income, waiting at least six months provides ample time for our credit reports to update, and you to build a history of on-time payments. Many lenders may not even consider offering you a refinance earlier.
Is it bad to refinance?
Refinancing any loan is not inherently bad or good. This is one instance where individual circumstances really do make a huge difference.
For example, an individual with a fair credit score prepping to buy a home in the next few months might hold off to avoid credit inquiries and potential dings to their score. But, someone with the same credit score who is struggling to pay their bills, might consider a refinance to free up a little extra money in the budget.
Is refinancing a car loan worth it?
Again, the answer here depends on whether or not the benefits outweigh the risks for your personal situation. Can you afford to have additional credit inquiries? Does switching lenders bother you? Have you done the math to figure out how much more or less you could be spending with a refinance?
Car Loan Refinancing Example
Suppose you had a non-prime credit score – between 601 and 660 – when you purchased your car for $20,000, with a 7.5% interest rate and a 60-month repayment term. Your payment would be around $400 per month, and over the term of your loan, you would pay about $4,045 in interest.
Now, one year later, your credit score has improved enough – up to between 661 and 780 – that you qualify for a better interest rate. Your remaining balance is about $16,500.
If you refinance your car for another 60-months at 4.5%, your new monthly payment would be $307.61 and the total of interest you would pay is $2,765 (including the interest you paid from your first year). You would have the car paid off in 6 years, including your initial year. That's a savings of almost $100 per month and $1,280 in interest.
Taking the same math, if you didn't adjust the length of the loans and wanted to pay off your car in the remaining 48 months of your original loan, but with a better interest rate, your payment could be closer to $376 per month and interest would be $2,450.
Are the savings worth the application process and possible dings to your credit score? That's something you need to decide.
Advantages and Drawbacks of Refinancing
Refinancing a car isn't a decision to take lightly. Even applying for a refinance could affect your credit score, potentially making it more difficult to get lower rates or approval for other loans. Here are some pros and cons to consider.
- A lower interest rate. Lower rates could make it easier for you to pay off your car faster, and save money on interest payments over the life of the loan.
- Lower monthly payments. A better interest rate and longer loan terms could mean more cash in your wallet every month.
- Add extra money to your wallet. If you owe less than your car is worth, you could refinance for a larger amount (that's still less than the car is worth) and use the leftover cash to pay off another bill.
- Paying more interest. If you extend your loan, you could end up paying more interest since you're paying for a longer amount of time. You'll need to use a loan calculator or talk to your lender to find out if your current needs outweigh this potential extra expense.
- Switching lenders. In most cases, a refinance means you'll be working with a different lender. If you really like the lender you have, it may be worth giving them a call to see if they can work with you on the interest rate, rather than going through a refinance with another company.
- You might not qualify. Some lenders have an age limit on the vehicle or your credit score may be too low. If you apply and allow the lender your run your credit, you could unnecessarily ding your credit score. Consider checking your credit report(s) before applying.
- You may face prepayment penalties. Your current lender may have a prepayment penalty clause in your auto loan policy. If your lender does include this clause, crunch the numbers to figure out if the penalty could cost your more than the refinance is worth.
Who should I refinance my car with?
If you have decided to move forward refinancing your car loan, finding the right lender is the best way to make sure you get the best terms possible.
There are a few options when it comes to refinancing your loan. If you like your lender, you could talk to them first. If you have made your payments on time regularly, and qualify for better interest rates or other loan terms, they may be willing to work with you. If that fails, you'll want to chat with other lenders. This is an important part of the process and one you shouldn't skimp on.
Questions to Ask a Refinancing Lender
When researching potential lenders, make sure to ask the following questions. You may also be able to find answers on the lender's website since many of them are transparent about loan terms.
- Do you have any added fees (like loan origination fees)?
- Does your loan have an early payment penalty?
- How long will the refinancing process take?
- Do I need to continue making my regular auto payments until the refinance goes through?
- Is my interest rate fixed? (If you get into an adjustable rate, your rates could go up or down over the life of the loan)
- What is the monthly payment?
- What is the APR for the refinanced loan?
- Do you offer any other benefits?
The Bottom Line
If you do plan to refinance, doing so earlier rather than later could save you more money, especially if you qualify for a lower interest rate. But don't blindly leap into a refinance without looking at your budget, asking potential lenders the tough questions, and deciding if the benefits outweigh the risks for your situation.