Is It Worth It to Refinance Your Car Loan? The Pros and the Cons
People with existing auto loans may often wonder if it’s worth it to refinance. As with many questions concerning finances, the answer depends. Your credit profile, personal circumstances, and market conditions are all factors you should think about before you make your decision. You also want to consider the pros and cons of refinancing a car loan before moving forward.
If you’re one of those many people wondering whether to refinance your car, consider this informative guide that explains what auto loan refinancing is, how refinancing a car can both help and hurt you, what situations may call for refinancing, and what circumstances would not justify the decision.
Study all of the details carefully so you make an informed choice on the matter. Then, if you elect to go ahead with refinancing, learn some tips for getting through the process.
Thinking about refinancing? Easily compare rates from lenders below.
What Does It Mean to Refinance a Car Loan?
When you refinance your car loan, you’re swapping your existing auto loan for a new one. You use the new auto loan to pay off the balance of the original loan.
Then you start servicing the new loan. Why refinance? The idea is to save money. Therefore, the terms of the new loan should be preferable to those of the previous.
What Are the Advantages of Refinancing a Car Loan?
If your circumstances line up, refinancing your car loan can provide numerous advantages relating to your personal finances and debt.
Lower Interest Rate
The primary advantage of refinancing is that it may allow you to secure a lower interest rate compared to your current loan. The likelihood of a lower interest rate depends on your credit score.
The interest that lenders charge is a method of mitigating risk on their end. That’s why subprime loans have higher-than-average rates. In the view of these lenders, consumers with higher credit scores are more reliable, so the lenders don’t have to mitigate as much.
Lower Monthly Payment
There are primarily two ways in which refinancing your car loan can lower your monthly loan payment. The first is the lower interest rate, as mentioned above. The less interest you owe, the less you’ll need to pay to keep up with it.
The other way is by extending your loan term, which refers to its life span. This works by spreading the sum of your loan across a larger period, allowing you to pay less of the premium per installment.
Cash-Out Refinancing
Cash-out refinancing is a type of loan that allows you to borrow additional money against your vehicle’s equity. In a nutshell, equity refers to the difference between your loan balance and your vehicle’s value.
If you have positive equity, your vehicle’s value is greater than your loan balance. With that, cash-out refinancing provides you with some extra cash, which you can put toward other financial needs. The downside to this is that you’ll have more debt to your name.
Early Payoff
Let’s say your financial situation has improved since you took out the original loan. If that’s the case, refinancing could allow you to renegotiate the loan for a shorter term so you can pay off the entire balance earlier than expected.
This route would provide a path to full ownership of the vehicle while avoiding prepayment penalties.
Debt Consolidation
Do you have numerous auto loans across multiple vehicles? If so, refinancing introduces the opportunity to take out a new solitary loan that covers all of them. Consolidating your debt in this fashion provides its own set of benefits.
For one thing, you’ll have an easier time managing your payments since you have only one payment every month. For another, you may see your credit score rise even further owing to a reduced credit utilization rate.
What Are the Disadvantages of Refinancing a Car Loan?
Before you decide that refinancing your existing loan is the best move, be mindful of the potential disadvantages you may experience.
Higher Interest Overall
Though one of the potential advantages of refinancing is a lower rate, you could end up paying more interest overall depending on the stipulations of your new loan.
Specifically, if you decide to extend the term of your loan, you’ll have more installments of interest along with monthly payments. If the new loan term is long enough, your combined interest could exceed the amount of your original loan.
To understand, consider this example. Let’s say your current loan is for $15,000 across 36 months with a 15% interest rate. Your monthly payment would be $520, and the total interest you’d pay on that would be $3719.
Now imagine that you’ve decided to refinance that $15,000 loan for a 72-month term at 10% interest. Your monthly payment would drop drastically to $278, but you’d owe $5008 in interest. That’s a difference of $1289. It’s up to you to determine whether the month-to-month financial advantage is worth the overall cost.
Additional Charges
When you apply for any loan, you can expect to pay a variety of additional charges. When it comes to refinancing, you may have to cover lender fees, title fees, and closing fees. There may even be charges associated with closing out your original loan before its term is up.
So before you decide to go ahead with refinancing, determine what additional costs you’ll have to pay. If the initial cost is too much, the process itself may not be worthwhile.
The Risk of Becoming Upside-Down
By refinancing your car, you could be increasing your risk of becoming upside-down on your loan. This happens when you extend the loan term, as you’re allowing the vehicle more time to depreciate. If the new loan term is long enough, or your balance was too high to begin with, the vehicle’s value will eventually drop lower than the amount you still owe.
Then, should you decide to sell your vehicle or trade it in, you’d have to pay the difference to the lender. In some cases, that could be thousands of dollars, potentially negating any savings you may have realized from a lower interest rate or monthly payments.
When Does It Make Sense to Refinance a Car Loan?
To ensure you’re making the best decision, you should understand the circumstances in which it makes sense to refinance your car loan. If any of the following situations apply to you, you may be among those who would benefit from auto loan refinancing:
Your Credit Score Has Risen
If you’ve been making your auto loan payments consistently and on time, chances are that your credit score has risen since you took out the loan. An individual’s credit profile is one of the factors that influence the terms of their loan.
So if your score is now higher, you can reasonably expect to get preferable terms on loans hereafter. Moving on to a new loan, then, could mean lower interest rates.
Make sure you do a detailed comparison of the current costs vs the total costs of the refinance taking into account loan fees, the remaining term of the loan, and the new rate to ensure you are getting a net benefit from refinancing. If the loan fees are too high or the term left is too short, you may end up paying more even with a lower interest rate.
Auto Rates Have Decreased
Rates for auto loans have a direct correlation with the prime rate, which financial institutions use as a reference for determining the terms of their loans. The prime rate may fluctuate in response to various economic factors. If the current rate is such that it works in your favor, you could do well to refinance your current car loan.
Your Current Loan Was through a Dealer
Auto buyers commonly finance purchases through the dealers where they bought the vehicles. Often, dealer rates are substandard compared to dedicated financial institutions. If your current loan was through a dealer, refinancing could get you a better interest rate.
You’re Struggling to Keep Up
Your personal circumstances are an important factor in determining whether it’s good to refinance your car. If you’re having a hard time keeping up with the payments for your existing loan, you may want to get a new loan with a more manageable monthly payment.
Keep in mind, however, that a lower monthly premium is often the result of a longer loan term. In that case, you could end up paying more overall because of the interest. You may want to consider trading in your vehicle for a more affordable vehicle with a lower monthly payment as an alternative.
When Is It Not a Good Idea to Refinance a Car Loan?
While refinancing can help many people improve their financial situation, it’s not suitable for everyone. In the following circumstances, it would not be a wise move to refinance an auto loan:
Being Upside-Down
When someone is upside-down on their auto loan, they owe more on the balance than the vehicle is worth.
Imagine, for example, that you still have $20,000 to pay on your loan but your car has depreciated to a value of $17,000. When that happens, lenders probably won’t approve you for refinancing.
Owning an Older Model
Lenders may consider the state of your vehicle to determine whether to approve your refinancing application.
Say you’ve had your car for over 10 years and it has six digits’ worth of miles on it. Depending on the lender you want to work with, they may decide that your vehicle is too old or too used to qualify.
Rising Interest Rates
Just as decreasing auto rates can be a positive indicator for refinancing, rising rates may indicate that you’re better off with your current loan terms.
If you decide to swap out your loan when the market isn’t in your favor, you could end up paying more interest than you would have originally.
Nearing the End of the Loan Term
Are you less than two years from paying off your current loan? The general rule of thumb is that you’re unlikely to realize much of an advantage from refinancing at that stage, so you might as well stick with your current terms.
Tips for Refinancing Your Car Loan
If you’ve decided auto loan refinancing is the right move for you, heed these tips to maximize your chances of getting the best rate possible:
Check Your Credit Score
Your credit score will have a direct bearing on your approval for refinancing. Preempt any surprises by checking on your score before you apply.
Also, keep an eye out for any discrepancies. You can improve your score by disputing and correcting any errors you find. That, in turn, will help you get a better interest rate on refinancing.
Crunch the Numbers
Use free online resources to run the numbers before you start looking in earnest for refinancing lenders. For example, use car payment calculators to determine how much you can save in interest and monthly payments depending on various loan factors, such as length and interest rate. This way, you’ll have a better idea of what to look for in a lender.
Shop Around
Great rates may be out there, but you have to look for them. Get and compare rate quotes by prequalifying. That way, you can avoid lenders making hard inquiries on your credit report, which would lower your score.
If the lenders you want don’t offer the option to prequalify, you can prevent a hit to your credit score by submitting your applications within a particular time frame. The major credit bureaus promote comparison shopping by allowing hard inquiries within a 14-day period.
Gather Your Documents
When you find the right lender for you, facilitate a smooth process by collecting all of the documents you need to complete the application.
At the very least, you’ll probably need your driver’s license, Social Security number, proof of income, proof of insurance, vehicle information, and a copy of your existing loan contract.
Finance Editor
Jim Slavik is a financial services expert with 30 years of strategic and operational experience including leading underwriting, loan administration, customer service and collections. He has held C-suite credit operations roles for Fortune 100 and private equity companies for credit cards, personal loans, lease-to-own, auto loans, mortgages, and insurance for prime and sub-prime borrowers.
Currently Mr. Slavik is an independent financial services consultant for private equity firms and a contributor for expert networks such as GLG, Guidepoint, and Level company amongst others.
