The Pros and Cons of Refinancing a Car Loan
If you’re running low on money or see a better interest rate advertised, refinancing a car loan can seem appealing. While you will sometimes get a better deal from a different company, it is essential to take a close look to make sure you will benefit from refinancing. Refinancing has pros and cons, and the best choice will depend on your situation.
Refinancing your car can be helpful in some situations:
- If you need to save money immediately, whether to free up cash for an emergency expense or because of a sudden drop in income
- If you have improved your credit score since you first took out a car loan, as you may have access to better interest rates
Reduce Your Interest Rate
One of the best reasons to refinance a car loan is if you have an opportunity to reduce your interest rate. If you previously had no credit or bad credit, it is worth checking into refinancing your car loan after a couple of years to see if you receive better offers. Your credit score may have improved enough to qualify you for a lower interest rate. With a lower interest rate, you will be able to pay off your loan faster or lower your monthly payment while paying it off at the same pace. In either case, you'll pay less over the life of the loan.
Lower Your Monthly Payment
Sometimes, an expensive occurrence such as having a baby, unexpected medical bills, or a natural disaster can put you in a situation where you have to reduce your monthly expenses. Refinancing might allow you to extend the duration of your loan, thereby lowering your monthly payments. For instance, if you owe two more years on your current loan, it may be possible to refinance and extend the term to four years.
Adding two years onto your loan should substantially lower your monthly payment, depending on the interest rate you get. You will be paying for two years more, but you will free up some cash on a monthly basis, helping you get through a rough patch. Keep in mind, though, that this will also mean that you'll pay more interest over the total life of the loan.
Changing lenders can be a pro or a con, depending on the relationship you have with your current lender. If your lender has poor customer service, changing lenders could be a benefit. If you like your lender, you can try to refinance with them, but you may need to look elsewhere to get the best rate.
Improve Your Cash Flow
If you currently owe less than what your vehicle is worth, you may be able to access more cash by refinancing. For instance, let’s say you have owned your vehicle for three years. Your vehicle is currently worth $8,000, and you still owe $5,000 on your auto loan. You need money for a small home improvement project. One option would be to refinance your vehicle for $6,500. You will still owe less than what the vehicle is worth and have $1,500 of new money available to spend after the new loan pays off your previous $5,000 balance. The $1,500 can now be used for your home improvement project.
Be careful, though. A car, unlike a home, is always a depreciating asset that can lose more than 10 percent of its value within the first month of ownership and more than 20 percent within the first year.
You don’t want to risk going underwater on your loan—that is, owing more on your car than the car is worth.
Understand the Costs of Refinancing
Sometimes you can refinance with a lower interest rate, but because the loan is extended, you will actually pay more over the length of the loan. Use a loan calculator to make sure you are saving money overall. Getting the lower monthly rate might be what you are looking for, but if you really want to pay less overall, it is important to do the math.
For example, if you have a $5,000 loan with a 10% interest rate paid throughout two years, you will pay $5,537 in total. However, that same loan extended throughout five years will end up costing you $6,374. That’s $837 that could have been spent on something else. So make sure you extend your loan only if you need to do so.
Freeing up cash quickly is sometimes the only reason for refinancing a car loan. Beware of higher interest rates, though, because most lenders charge higher rates on older vehicles. When you're looking to refinance your aging car, you might be surprised at the interest rate available to you compared to what you received when the car was new or almost new.
Many banks, including USAA Bank and Bank of America, do not charge an application fee for an auto loan refinancing.
The Bottom Line
Consider all of your options before you commit to refinancing your car and check around to see what interest rates are available. Keep the length of the loan as short as your budget will allow. Getting the shortest loan term combined with the lowest interest rate will ensure you are getting the best car loan possible.