Financing is often necessary when you’re buying a car, as most people don’t have the funds to pay for the vehicle in full. When you initially borrowed money to purchase your vehicle, you probably weren’t over the moon about putting yourself in debt. A car loan locks you into monthly payments and can come with high interest rates that result in your paying thousands of dollars more than the car is worth.
Unlike the saying, “all things get better with time,” auto loans typically result in the borrower paying more money as time goes on. They might have to make excessive monthly payments for an extended period with no end in sight. As you continue to fork over your cash while seeing advertisements for loans with much more favorable terms, you might wonder where you went wrong.
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It’s normal to find yourself in this predicament and look for the quickest way out. Maybe you shorten your loan term by getting a second job to pay more than the minimum payment each month. Maybe you trade in your vehicle at a car dealership. Or, maybe you change your name, move to Canada, and hope the lender will let bygones be bygones.
As you consider your options, don’t forget about the possibility of refinancing your car loan. Refinancing lets you keep your beloved car and makes ownership affordable through more favorable loan terms. Learning more about this method and weighing its pros and cons will help you make a practical and financially sound decision.
What Does It Mean to Refinance Your Car?
Refinancing your car might sound complicated, but the process is fairly common and simpler than what you’d expect. Essentially, it involves replacing your initial car loan with a new car loan.
When you obtain your new loan from your current lender or a new lender, the new lender pays off the old loan. Then, you start making payments to the new lender. The goal of refinancing is to get more favorable terms, whether they be lower interest rates, lower monthly payments, or a shorter loan lifetime.
Example of a Refinanced Car Loan
You can better understand auto refinancing by considering an example. Imagine you take out an auto loan for $25,000 at a 6% APR for 60 months. Your monthly payment ends up being $483.32. You pay a total of $5,799.84 over the first 12 months, meaning you still owe the lender $19,200.16. You decide the monthly payments are too high, so you shop around to refinance your car loan.
One lender offers you a refinanced car loan at a 3% APR for 60 months. You agree to this loan term, so the new lender pays your old lender the remaining $20,579.92 you owe. Then, you must pay back this amount to the new lender. Because you’re borrowing $20,579.92 from the new lender at a 3% APR for 60 months, your new monthly payment is $369.79.
In this example, refinancing not only makes your monthly payments more manageable but also reduces the overall interest you pay. If you stuck it out with the original loan, you would pay a whopping $3,999.20 in interest over the loan’s lifetime. The refinanced loan requires you to pay $1,607.73 in interest plus $1,379.77 in interest from the first 12 payments of the initial loan.
Thus, the total interest if you refinance would be $2,987.50 compared to the $3,999.20 in interest on the original loan. Refinancing would save you an impressive $1,119.49 over the lifetime of the loan, simply by locking in a better interest rate.
That said, you now have another year of financing payments to make before you own the vehicle (you had 4 years left on the old loan you refinanced for another 5 years) so make sure you consider if you want to keep the car another year and if there is any risk of the value dropping below the remaining loan amount during that time.
Is Refinancing Your Car a Good Idea?
The example above highlights why refinancing your car loan can be a good idea, but here’s a closer look at the potential benefits:
Reduced Interest Rates
When you took out your initial car loan, you might’ve been the victim of high interest rates. Market conditions at the time could’ve forced you into a higher-than-normal APR. It’s also possible that you failed to shop around and picked the first lender you came across. Or, a poor credit score could’ve prevented you from accessing competitive rates available to borrowers lenders consider “safe.”
Regardless of the reason your interest is so high, it can be frustrating, especially when you see lenders advertising low rates. High APRs cause you to pay significantly more than the car is worth over the lifetime of your loan. Therefore, one of the most sought-after benefits of refinancing is the reduced interest rate. By obtaining a lower interest rate, you save money by paying less overall for your loan.
Lower Monthly Payments
Because refinancing can lower the amount of interest you pay, it makes sense the strategy can also lower your monthly payments. Even if the overall savings aren’t significant, paying less per month can help you manage your budget more efficiently. Refinancing your auto loan is a simple yet effective way to make room for life’s other expenses.
Shortening Your Loan Term
When you have a lengthy auto loan term, it can feel like there’s no light at the end of the tunnel, even if you make your monthly payments on time. One option for shortening your loan term is paying more than the minimum required monthly payment, though your lender might charge excessive fees.
Alternatively, refinancing can help you shorten your loan term and save you money by ensuring more of your cash goes directly to the principal amount you owe instead of interest.
When Should You Refinance Your Car?
Though you might be eager to reap the benefits above, don’t apply for a new loan just yet. Your timing must be perfect if you want to take full advantage of refinancing. Here are some conditions that indicate now is the time to swap out your old loan for a new one:
Your Car Is Still New
A new vehicle can lose as much as 20% of its value during the first year of ownership. Even if you take good care of your car, it will continue to drop in value the longer you own it.
This information is essential to know because lenders prefer to help borrowers refinance if their cars have a decent amount of equity. Take advantage of refinancing options while your car is still newer. If you wait too long, your car might not be worth enough for lenders to consider your application.
The Market Is Better
You might have applied for your initial loan when the market’s average APRs were insanely high. Fortunately, refinancing helps you take advantage of constantly fluctuating interest rates. Research interest rates from different lenders to determine when they’re lower than your current rate.
You Have a Better Credit Score
Because lenders accept risk when they distribute loans, they try to work with reputable borrowers. These target consumers are usually those with good credit scores, as they’re more likely to make timely payments than someone with poor payment history.
When lenders qualify subprime borrowers, they raise the interest rates to accommodate their increased risk. So, if you applied for an auto loan when your credit score was subpar, you might have a high APR. Fortunately, you might be eligible for a lower rate if your credit score has since improved.
You Have Increased Income
If you start making more money as the result of a new job or another income source, a smart first move is to get out of debt.
This increased income gives you the power to make bigger monthly payments and shorten your loan term. While you could take this approach via your existing loan, refinancing can help you avoid prepayment penalties.
You Need to Trim Your Monthly Budget
While this point appears to contradict the one above, remember that refinancing can help you meet different financial goals. Some people interested in refinancing look to trim their monthly budgets, as new loans can result in lower monthly payments.
You might pay more over the life of your loan, but the lower monthly payments help you keep your budget in check and ensure you can afford other monthly expenses.
What Are the Downsides to Refinancing Your Car?
If you don’t choose the right lender or get a new loan at the wrong time, refinancing your car loan can have significant downsides. For instance, you might end up paying excessive prepayment penalties or other fees to your current lender.
You might pay more in interest if you opt for a longer loan term. Additionally, people who refinance often pay for service protection products on their new loans that cost a pretty penny.
Is It Worth Refinancing Your Auto Loan to Get 3% APR?
A 3% APR is attractive to many borrowers, especially when you consider the average APR for a car loan for someone with good credit is nearly 5%. However, you must consider everything refinancing encompasses to determine whether you should accept a new loan with this APR.
For instance, imagine you secure a new loan with a 3% APR compared to your old loan’s APR of 6%. Even though you might pay significantly less in interest with this new loan, prepayment penalties from your current lender might exceed your potential savings.
Will Refinancing Your Car Affect Your Credit Score?
Your credit score might dip because of the hard inquiries lenders conduct. However, the impact is minimal and often worth it because of the benefits of refinancing your auto loan.
Determine If Refinancing Is Right for You
Refinancing can have significant benefits ranging from lower interest rates to lower monthly payments, but be sure to consider the downsides.
Factoring in potential fees will help you determine whether to get a new loan or stick out your old one. If you decide to go the refinancing route, comparison-shop and approach the negotiation table with a good credit score.
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.