What Is Auto Loan Refinancing?
Auto loan refinancing is the same as home loan refinancing. You create a new loan agreement with either the same lender or another lender to pay off your current loan and begin a new loan at a lower interest rate. You can either extend the loan term for another four to five years (sometimes more), which reduces your monthly payments, or you can shorten the loan term and keep your payments about the same, which will pay your loan off more quickly and save on interest payments.
When is refinancing a good idea?
Let's say you buy a brand new car with a reasonable interest rate on a five-year auto loan through a lender who pays a little toward your principal each month (the principal is the actual amount of your loan, minus the interest your have to pay). A year later, interest rates for used car loans have dropped below the interest rate you got on your new car loan. Should you refinance your car loan? Probably.
Be certain that your current loan has no prepayment penalty and there are no extra processing fees charged by the new lender. Refinance your car loan for four years and you will lower your monthly payments and save hundreds of dollars in interest. Why four and not five? The longer your loan term, the more you will pay in interest.
Another good time to refinance is if you ended up with a really bad auto loan with a disgusting interest rate, like 20%. Since lenders usually take the bulk of their interest up front, you will probably discover, much to your horror, that one year later you still owe about the same on your auto loan, even though you've paid several thousand dollars in payments.
If you have made your payments on time, thus improving your credit, and you can qualify for an auto loan with a lower interest rate, you must seriously consider refinancing that car loan. You will not save hundreds, you will save thousands; especially since many people who refinance in this situation drop their interest rate by 3% or more. Even if your current lender charges a prepayment penalty, it may still be worth it.
When Should You Not Refinance?
If your situation does not fit the previous scenarios, you probably do not need to refinance. You would think that the opportunity for a lower interest rate would automatically be a good thing. Let's consider the second scenario, the person stuck in the high interest auto loan. You are not in a situation to refinance for two to three years. At that point, you have paid thousands and thousands of dollars in interest and very little on your principal. However, now you are in the second half of the loan term, and the bulk of your payments are going toward your principal. The amount you owe is steadily decreasing each month.
If you refinance, you start over again with a brand new loan and a lower interest for another four to five years. For the next few years, the bulk of your payments will once again be going toward interest instead of the principal on your loan. If you had just stuck it out with your original loan, you would be done. You would own your car. Instead you refinanced and have two to three more years of payments. Did you save money? Probably not.
If you are new car financing with a reasonable interest rate and find that interest rates for new car loans have dropped 2%, you may figure that 2% would save you money. However, your car is now a used car, and used car loans have higher interest rates than new car loans. You may find that processing fees and very little change in interest make it a waste of time to refinance.
The best way to decide if you should refinance your car loan is to determine how much money, if any, you will save. Find out how much you will pay over the life of your loan in both the principal and interest, and then find out how much you would pay over the life of a new loan if you refinanced, including any pre-payment penalties and processing fees. You will know by comparing the two amounts if refinancing makes sense for you.
by Alisa Elizabeth King Terry