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Pros and Cons of Refinancing Your Auto Loan

Mayra ParisDec 8, 2017

Choosing to refinance your auto loan is a big decision—almost as big as buying the car in the first place. Loan refinancing consists of replacing an old loan with a new one, essentially paying off your current loan with money borrowed through another loan with different terms. Refinancing is a useful tool if you think you can save a meaningful amount of money by getting a new loan with more favorable terms than the loan you have now. But there are dangers related to refinancing you should be aware of before taking the leap. Read on to find out what they are.

When Is the Best Time to Refinance Your Car?

It’s hard to say when the best time to refinance is. Each lending situation is unique to the borrower’s circumstances and goals. The best time for you may not be the right time for someone else.  Were we to describe the optimal conditions for refinancing an auto loan, it would include a good credit score, favorable interest rates in the market, and a car worth more than what you still owe on the loan. If these three things are true, you should be able to get a new loan at a low interest rate and with a term of moderate length.

However, this does not mean that refinancing your auto loan won't be worth your time if you fail to meet these criteria. Remember: each lending situation is unique. Depending on what you want to achieve by refinancing, you may still find it's a good idea.

Refinancing to Lower Your Interest Rate

Lowering the loan interest rate is the most common reason people refinance their auto loans. After all, your interest rate is the most crucial number in your loan agreement. It determines how much interest you'll pay on top of the value of your car and other taxes and fees. Often, it’s also the easiest number to change.

Your lender will look at your credit score and credit history when deciding which interest rate to offer you. If your score was bad when you bought your car, but has improved significantly since then, refinancing your loan could get you a much lower interest rate. This may decrease your monthly payments as well as the amount of interest you will pay in total.

Sometimes, you can still get stuck with a high interest rate even if your credit score is good. Interest rates are largely determined by your country's monetary policy, and the general state of the economy. If interest rates have gone down since you got your car loan, and you think a new interest rate will considerably decrease your interest charges, then you should consider refinancing your car loan.

To get the most out of refinancing to lower your interest rate, first, make sure that your credit score is high enough to get you a lower interest rate than the one you have now. You don’t want to go through the entire lending process only to get a rate that is only marginally lower than the one you have now.

Checking your score and credit history is just good practice when applying for a new line of credit. Take advantage of the three free credit reports available every year and make sure all the information on the reports is correct, so you can avoid unpleasant surprises when applying for refinancing.

You should also look closely at your current loan agreement to see if there are prepayment penalties or early payment fees. Lenders generally don’t like it when you pay off your loan early, so they write fees and penalties into your loan to make sure they make a profit. These penalties still apply when you refinance, so make sure any existing prepayment fees are less than whatever you will save under the new loan. Otherwise, you may be better off keeping your existing loan.

Refinancing to Lower Your Monthly Payments

If your financial situation has worsened since you took out your car loan, refinancing and receiving a new loan with a longer loan term and lower payments could help. This strategy is usually discouraged because in extending the term of your loan, you will increase the total amount of interest you will pay. However, if you really can’t afford the monthly payments and are at risk of defaulting, this option could help you keep your head above water. Regularly missing loan payments has a very negative impact on your credit score, which is the last thing you need when your financial situation is unstable.

If this is the route you’re thinking of going, be careful you don’t end up trapped with an upside-down loan. This happens when your car’s value is less than the loan balance you still owe. Auto loans usually get upside down towards the end of the loan term—cars lose value at a rapid rate until they hit the five-year-old mark, when depreciation becomes steadier—but this isn’t a problem unless you want to sell or refinance.

If you want to sell a car that's worth less than the loan balance on it, you may end up having to repay the loan even after you sell it. The proceeds from the sale probably won’t be enough to pay off the loan. And if you want to refinance an upside-down loan, you may not even get approved. Lenders are hesitant to approve loans for older cars that may stop working shortly after the loan is approved—borrowers are less likely to continue making payments on a useless vehicle.

Before you refinance to lower your monthly payments, check the value of your car with a pricing guide like the Kelley Blue Book or NADA Guides to ensure your loan isn’t upside down.

Can You Refinance to Get a “Cash Out”?

Refinancing with cash out means refinancing your car when its value is higher than the remaining loan balance and taking the difference as a cash payment to you. For example, if your car is currently valued at $15,000, but you only owe $10,000, your car has an equity of $5,000. A cash-out refinance would give you the amount remaining after paying off your current loan. This type of refinancing may be tempting for people who need quick access to money.

However, you should be wary of cash-outs. It’s very easy to end up with an upside-down loan under cash-out refinancing, even if you make all your payments on time. An accident can drastically decrease your auto value, and your car will only continue to depreciate.

Another issue with cash-out refinances is that the interest rates tend to be higher than if you were simply doing a traditional refinance. If you do the math, you may find the total interest amount you will pay is far higher than the cash-out you will receive.

Does Refinancing Hurt Your Credit?

Refinancing your auto loan won’t hurt your credit directly. The credit inquiries lenders make when you apply for refinancing do lower your credit score by a few points, but your credit should bounce back within a few months. To further decrease the impact of the inquiries, you should make all your refinancing applications within a small period of time so credit bureaus know you are shopping around for a single loan, not several. As long as you make your loan payments consistently and on time, there’s no reason for your credit to go down.