When most people buy a car, they finance it, meaning they take out a loan to purchase the vehicle. Some buyers finance through the car dealership, and others bring their lenders, such as banks or credit unions. Sometimes, lenders charge high-interest rates for car loans. This article covers the pros & cons of refinancing a car because it often makes sense to refinance later to get a better deal with better interest and more equitable terms.
What is Refinancing?
Refinancing refers to paying off the original loan with a new loan with different terms, possibly a better interest rate, and a lower principle. When someone applies for refinancing, they must go through a process similar to the one when they first bought the vehicle. However, the borrower may have partially paid off the initial loan, and refinancing could lower the monthly payment.
Upon closing, the lender will first pay off the original car loan and then set up a new one with the revised interest rate, terms, and monthly payment. The car buyer may or may not have to deposit money to close the new loan. The vehicle will be used as collateral to secure the loan.
Refinancing may take longer than the original purchase, especially if the buyer used dealer financing. There is also the question of whether or not refinancing is worth it. Car owners should always review their finances first and speak to a credit specialist before making any changes. The federal government has national programs to help consumers with credit, debit, and financial decisions.
When Should You Refinance Your Car?
The decision to refinance a vehicle can be tricky. There are instances when refinancing might worsen things and others where it will dramatically improve the vehicle owner’s situation.
If the loan on the vehicle is higher than what the car is currently worth (fair market value), an owner should skip refinancing. If they just bought the car and haven’t made one payment yet, that is another reason to stop refinancing. Experts suggest not refinancing for at least six months after purchase. Some loans have prepayment penalties. If the original loan came with payoff sanctions, the owner should not refinance unless necessary. Another reason not to refinance is if the car owner’s credit score has dropped since buying the vehicle. They could have trouble getting financed with a new company. It’s better to wait until their credit score has improved.
Reasons a car owner should refinance.
| Scenario | Description | Consideration |
|---|---|---|
| Interest Rates Drop | Refinance if market interest rates have fallen since you secured your original loan to benefit from lower rates. | Compare current rates to your existing rate. |
| Improved Credit Score | If your credit score has significantly improved, refinancing can secure you a better interest rate and terms. | Check your credit score before applying. |
| Financial Situation Changes | A change in your financial situation, such as increased income or decreased expenses, might make refinancing viable for better terms. | Assess your financial stability and needs. |
| Loan Is Not Too Old | Refinancing is more beneficial early in your loan term before too much interest has accrued and while the principal is higher. | Calculate the remaining interest and principal. |
| Market Value of Car Is High | Ensure your car’s market value is greater than the outstanding loan balance to avoid being underwater on your loan after refinancing. | Get a current appraisal of your vehicle. |
Financial trouble
When someone is in financial trouble if they own a car, it may provide a solution. Refinancing a vehicle could help lower monthly payments and sometimes even offer a cash payout for other expenses. In addition, if the loan required is far less than the car’s value, the owner could use the excess to pay off high-interest credit cards or other debts.
Improved credit score
Car loans are typically easy to qualify for because the car provides built-in protection against defaulting on the loan. If the buyer doesn’t make the payments, the lender can repossess the vehicle and sell it to get their money back. Therefore, even people with poor credit scores may qualify for a car loan. If someone gets a car loan but works hard to improve their credit score, they could apply to refinance the car and possibly get a new loan with a much better interest rate and terms. Lenders often base interest rates and terms on an applicant’s credit score. That is why it is so essential to keep good credit.
Change the loan’s term
Car loans may be structured using various terms. Some might be for three, five, or even seven years. The longer the period, the lower the payment. If a car owner wanted to lower their amount, shorten the loan term, and pay off the car quicker, they could refinance to achieve this goal. Keep in mind that extending the duration of an auto loan could end up costing more in the long run.
Interest rates have dropped
If a buyer purchases a vehicle with high loan rates, they could save a lot of money by refinancing when interest rates fall. Getting a better interest rate could save a ton of money over the life of the loan. For example, suppose a buyer purchased a car for $25,000 with an interest rate of 7% for a term of 60 months.
If the buyer pays every payment and keeps that loan, they will have spent a total of $29,702. However, if the car owner keeps the loan for a year, pays down the principal to $21,000, and refinances that for 48 months at a rate of 5% interest, they would pay a total of $23,214 on the new loan. The two loans combined total $27,214, meaning the buyer would save $2,488 in interest.
Emergencies
A person experiencing an emergency could potentially refinance their car loan to get some extra cash to pay for unexpected medical bills or other expenses.
Risk of repossession
If the car buyer doesn’t make timely payments, they risk the lender repossessing the vehicle. In some cases, it might make sense to refinance quickly, making the payments more affordable and avoiding repossession.
Bad lender
It’s possible that the initial lender could have terrible customer service or a complicated payment system to use. If working within their system is too cumbersome, customers may choose to refinance to work with a more flexible, modern company.
Requirements to Refinance
Before agreeing to refinance, the lender may require a few items. They may use a VIN database to gather details about the vehicle. Since the car will be used as collateral, they want to ensure it is the right vehicle and that the information on the VIN matches what the buyer provides. They can use a VIN search to determine if the car has any water, fire, or flood damage or has been in any accidents. Some other requirements a lender might ask for include:
- Pay stubs for the last month of income.
- The last two W2s from previous years.
- Bank statements for at least two months.
- Canceled checks showing payment of the current auto loan.
- Proof of employment.
- Proof of automobile insurance.
- The original purchase documentation for the car.
- Name, address, and phone number of the current lender.
- A copy of the car owner’s driving records.
- A copy of the person’s valid driver’s license.
- Tax returns for the last two years.
Pros of Refinancing a Car
There are dozens of great reasons to refinance a vehicle. Some of the most common pros of refinancing a car include:
Better Interest Rate
Interest rates vary significantly from time to time and within different financial institutions. For example, a car buyer might be offered a great promotional rate from the dealer but expect to pay two points higher with a bank loan.
Credit unions often offer their customers lower auto rates, which can be an excellent option for refinancing a vehicle. Since interest rates fluctuate quickly, it is essential to lock in a lower rate as soon as they drop. Lowering the interest rate on the loan means paying a lot less for the same car. Refinancing can help car owners save hundreds and even thousands of dollars throughout the loan.
Read more: Cars and Credit: 14 Things to Know to Get the Best Deal
Lower Monthly Payments
Depending on the loan terms (how many years the car buyer must pay) and the interest rate, a monthly car payment can be very affordable or terribly expensive. Refinancing to adjust the interest rate down or extending or shortening the loan term can help make the monthly payments more affordable. If the person is doing well and wants to pay less for the car, they may consider shortening the term to pay less interest, although the car payments may increase slightly. Over the long term, however, they will pay less.
Positive equity
Once the car buyer pays down the initial loan so that the vehicle’s fair market value is more than the remaining principal, the car has positive equity. That equity is valuable, and car owners can actually borrow up to 50% of the car’s value. They could take out a new loan if they need extra cash for other expenses. A portion of that would become their new car loan. The borrowers could use the excess amount for anything they like. However, borrowers should remember they will be paying interest on any cash proceeds they get from refinancing a car loan.
Paying Off Your Previous Loan
If, for some reason, it would benefit the car owner to pay off their initial loan, they should consider refinancing. Reasons to do so may include lower interest rates, change of terms (longer or shorter time frame), and changing lenders for a better customer service experience.
Taking Advantage of a Promotional Deal
Many lenders offer great deals to get people to refinance cars and even homes. These deals may include cash bonuses, waived fees, lower closing costs, and promotional interest rates. Savvy car owners could make money on a refinance just by taking advantage of a great deal when it comes along. However, be careful of deals that sound too good to be true. For example, some offer deferred payments, but the lender may tack on extra interest even though payments don’t start immediately.
Cons of Refinancing a Car
Although there are plenty of pros to refinancing a car, there are also some cons, which may include:
New Payment and Fees
Once the borrower signs the loan documents, they are bound by a new car payment. It’s too late once the process has been closed. They may also have to pay steep fees at closing. If they are refinancing due to financial issues, coming up with the money to close may be difficult.
Might Cost More in Interest Over the Long Run
If someone refinances their car too often or continues to extend the terms (life of the loan), they could end up paying a lot more in interest. Some things sound good on paper and may provide a quick fix, but the long-term solution may not be financially feasible.
Possibility of Ending Upside Down on Your Loan
The older the car gets, the more the value decreases. If someone refinances a used or older car more than once, they could end up upside down where the loan is more than the car is worth.
If the lender realizes this, they could demand cash to offset the potential loss. Lenders rely on the fair market value of a vehicle to pay off the loan if the owner defaults.
Negative Equity
When a person owes more than something is worth, that is called negative equity. It can happen if a home mortgage is refinanced too many times, and it can also occur with vehicle loans. Having equity in a car or home is well worth the effort. It provides a bargaining chip and emergency funds if you need to refinance to free up cash.
Things to Watch Out for When Refinancing a Car
Whenever someone borrows money, there are risks involved. To avoid any pitfalls, review the list below of things to watch out for when refinancing a car.
- One of the most significant risks is refinancing a vehicle but not making timely payments. Not only can this severely damage the borrower’s credit, but they could risk losing the car, too. This is because the car will be used as collateral, and the bank or credit union could repossess it if the owner defaults on the loan or doesn’t make payments on time.
- Drowning in debt is another possible risk when refinancing a vehicle. Consider all the other expenses that must be paid along with the new car loan before deciding to refinance or borrow any additional cash. Other options may be available to relieve the problem without taking on more debt.
- Banks and other financial institutions look at every item on a person’s credit report. If they have too many outstanding loans, the bank will not be eager to loan them additional funds. Therefore, if someone plans to buy a home within the year, refinancing their car could hurt their mortgage options. Lenders do not like to see too many loans or new credit right before handing over money for a large-ticket item like a home. Limit the number of credit inquiries affecting your ability to borrow in the future.
- Watch out for loans that put all initial payments towards the interest. When the car buyer goes to refinance, the car’s value may be less than the principal, and they could have trouble getting a loan.
- Some lenders charge a lot in refinancing fees. Shop around to make sure the lender is not charging more than fair market value for the closing costs or document fees.
- Always use a reputable, well-known lender. Many fraudulent companies offer what looks like great deals, but they are really just out to make money off unsuspecting victims.
- Be careful of add-ons. Some dealerships will try to sell car buyers a lot of extras like rust protection and additional insurance when they purchase the car. Banks can also do that, so be careful of any lenders who try to push extras.
- If the car owner’s credit score is less than perfect, they may be enticed by what sounds like a great refinancing deal. However, often these deals come with strings attached or high interest rates. Always do your homework and compare lenders before deciding who to choose.
- There are no guarantees in life, and although a borrower might be sure this is the last time they will refinance their car, they might be wrong. It is important not to refinance with a company that includes payoff penalties in the contract. Payoff penalties could prevent someone from getting a better deal or lowering their payments when the opportunity strikes.
Alternatives to Refinancing a Car
Depending on the reason for refinancing a car, there may be other options available. For example, if the goal is to free up cash or reduce monthly expenses, consider the alternatives below that might solve the problem without the hassle of going through a refinance:
Personal Loan
If the issue is a short-term need for cash, sometimes a personal loan makes more sense than refinancing a vehicle. However, the borrower would need good credit and something for collateral to guarantee the personal loan.
Ask a family member or friend for help
Although it may be difficult or embarrassing, another option would be to ask a family member or friend for some short-term financial assistance. The initial pain of asking may be well worth the help. Then, give someone the boost they need to get through the difficult period.
Payday loans
Some credit unions offer payday loans which basically advance a recipient a percentage of their next paycheck. If timing is an issue to meet specific expense deadlines, it might be a good option instead of refinancing a car.
Use your home equity
Some people may use the equity in their homes to take out short-term loans to pay off debts. For example, if a person’s car loan payment was hefty, they could apply for a Home Equity Line of Credit (HELOC) and pay off the vehicle. The payments would most likely be much lower because the terms would be 10-30 years. A benefit of using your home equity is that it could save money at tax time with tax benefits for excess home mortgage interest.
Retirement plan loans
Some retirement plans let you take out loans against savings. However, keep in mind these loans could have adverse tax consequences and charge you fees. Learn about capital gains and how they affect taxes before choosing this option.
Related read: Can You Retire at 62 With 300k
Credit cards
For short-term expenses, someone could use a credit card to fund an unplanned expense rather than refinance their vehicle. However, credit cards tend to charge high-interest rates, and too much credit card debt can reflect poorly on the person’s credit score.
Cash/Savings
When unexpected expenses arise, people might be tempted to take out loans, but it could save a lot in terms of interest if they have any cash or savings available. Although no one likes handing over money or dipping into savings, the choice is clear when it comes to paying thousands in interest or losing a little off the top of a nest egg.
Credit counseling or debt consolidation
If a person has difficulty managing their finances and finds themselves heavily in debt, a great solution is to consult with a credit counselor or contact their financial institution to consolidate their debt. By combining many small debts, someone could reduce their monthly payments to a much more affordable amount.
There are always alternatives to a problem. Not everyone would want to refinance their car to solve a financial issue. Explore all your options before deciding what to do. Ask other people for help too, they may offer unique solutions to the problem.
How Refinancing Affects Your Car’s Equity
One often-overlooked aspect of car loan refinancing is its impact on your vehicle’s equity. Equity is the difference between your car’s current market value and the amount you owe on the loan.
Ideally, refinancing should help you build equity faster, especially if you secure a lower interest rate or a shorter loan term. However, if you opt for a longer repayment period to reduce your monthly payments, you might slow down the equity-building process or even find yourself in a situation where you owe more than the car is worth—also known as being “upside down” on your loan.
It’s vital to assess how refinancing will affect your car’s equity to ensure it aligns with your financial goals.
The Role of Refinancing in Your Overall Financial Plan
Refinancing your car loan shouldn’t be a standalone decision; it should fit into your broader financial strategy. Consider how the new loan terms align with your financial objectives, such as debt reduction, savings growth, or investment plans.
A lower interest rate can free up cash that you can redirect towards high-interest debt repayment, emergency savings, or retirement accounts. However, extending your loan term for lower monthly payments might offer immediate relief but delay your debt-free goals. Before refinancing, evaluate how this move fits into your larger financial picture to ensure it supports your long-term financial health and objectives.
When It Makes the Most Sense to Refinance
The timing of your car loan refinance can significantly impact the benefits you receive. Factors such as market interest rates, your credit score, and the age of your vehicle all play crucial roles. For instance, refinancing is most beneficial when interest rates have dropped since you took out your original loan or if your credit score has improved, qualifying you for better rates.
Additionally, consider the depreciation curve of your car; refinancing earlier in the loan term may be more advantageous before the car depreciates significantly. It’s also wise to avoid refinancing when you’re close to paying off your existing loan, as the costs may outweigh the benefits. Strategic timing can maximize your savings and ensure that refinancing contributes positively to your financial journey.
The decision to refinance a car comes with many positives and negatives. It’s also a personal one that everyone must make on their own, weighing all the information and choosing what is best for them. When refinancing, be sure to shop around, look for legitimate deals, and compare offers.
It is also helpful to consult with a trusted friend or family member to help make sure everything is valid, and refinancing is a good decision. Finally, consult the list of pros and cons above to cover all your bases and explore other options you may not have considered before.
This article Pros and Cons of Refinancing a Car originally appeared on Rick Orford.
This article originally appeared here and was republished with permission.
