Should You Ever Refinance a Car Loan?

More than half of used cars and a full 86.3% of new cars were purchased with a loan in the first quarter of 2016, according to Experian. The average new car buyer borrowed $30,032 for 68 months for their new ride, while the average used car buyer borrowed $20,723 for 66 months.

Compare those figures to last year’s, and you’ll notice an expensive trend. Each year, Americans commit to borrowing more money to buy both new and used cars – and to repaying their loans for an even longer stretch of time. Remember when most people took out a car loan for 48 months or less? These days, people are spending so much on cars, they’re forced to drag those monthly payments out longer than ever – and even up to 84 months.

Worse yet is the amount of interest we pay collectively. As the Experian study notes, the average interest rate on new cars was 4.79% early this year, while used cars financed at a dealership carried an average rate of 7.81%. Used car loans using independent financing, on the other hand, came with an average interest rate of 12.22% that quarter.

Imagine a $20,000 loan at 12.22% for 66 months. After forking over $418 per month for five-and-a-half-years, you’ll have paid $27,566 for a car that is now worth just a few thousand bucks.

Heck, even at 4.79%, you’ll pay a lot of interest to drive your new car off the lot. With the average new car loan of $30,032 set at 4.79% for 68 months, you’ll wind up spending $34,352 and forking over $505 per month for almost six years of your life.

Either way you cut it, that’s a high price to pay for a depreciating asset.

Should You Ever Refinance a Car Loan?

If you find yourself with a car payment you can’t really afford, you have several options to consider. Unfortunately, none of them are all that attractive.

First, you can attempt to sell your car or trade it in for something cheaper. If you owe more than your car is worth at this point, however, dropping your car is much easier said than done unless you’re willing and able to make up the difference in cash.

The second option is to bite the bullet and pay off your car. It might take a while, but you can save money on interest and speed up the payoff process by making additional payments towards your car loan. As long as your auto loan doesn’t come with prepayment penalties, this is a smart option to consider. Unfortunately, if you’re struggling to make your monthly payments in the first place, it’s pretty unlikely you’ll be able to pay more each month.

Lastly, some people also consider refinancing their car loan. While that might not seem like a great idea, there are times and situations where doing so actually makes sense.

Three Situations When Refinancing Your Car Loan Might Make Sense

Just like refinancing your home can help you save money on interest and lower your monthly payment, the same situation may apply to your car. Here are a few instances when refinancing your car loan might make sense:

  • Interest rates have dropped. If interest rates have dropped considerably since you purchased your vehicle, you might save money by refinancing your car at today’s low rates. This is especially true if you believe you can get a loan with a rate that is considerably lower than what you’re paying now.
  • Your credit score has improved since you took out your loan. If your credit score has improved dramatically since you purchased your new or used car, you might qualify for a much lower interest rate when you refinance, which could help you save quite a bit of money. Consider that 12.22% interest rate in the above example — that’s what many people are paying if they’re unable to qualify for dealer financing, probably due to less than perfect credit. If your credit score improves enough to secure a more reasonable rate, such as 5%, the savings would be tremendous.
  • You need a lower payment to avoid default. If you’re struggling to afford your car payment and worried about defaulting on the loan, refinancing into a new loan with a lower rate or longer term can help provide some breathing room. Just remember that extending your loan for a longer period of time will typically cost you more in the long run, not less. However, that’s a trade-off worth making if it spares you a default.

What to Consider When Refinancing a Car Loan

Refinancing a car loan can make sense in the situations described above, but that doesn’t mean there aren’t risks involved. Before you pull the trigger and jump into a brand new loan, you should consider these potential disadvantages:

  • Extending the length of your car loan can lead to paying more – not less – on your loan. While lowering your monthly payment can improve your cash flow, that doesn’t mean it will help you save money in the long run. By refinancing your car loan and extending the length of repayment, you can wind up paying more for your car than if you had simply stayed the course with your original loan.
  • Lowering your monthly payment could leave you ‘upside-down’ on your loan longer. If your auto refinance extends your repayment period, you might build equity at a much slower rate. Meanwhile, your car will depreciate in value. As a result, you might owe more than your car is worth, or be “upside down” on your loan, for a longer period of time.
  • Watch out for prepayment penalties. The vast majority of car loans don’t charge a prepayment penalty, but that doesn’t mean that yours doesn’t. Make sure your existing car loan doesn’t charge a fee to pay off your loan early. If it does, you’ll need to factor the cost of that fee into your decision.
  • Refinancing isn’t always free. Most of the time, you can refinance your auto loan without incurring any additional fees for doing so. Still, you should always inquire about fees or charges with your chosen lender before you pull the trigger.

If you’re stuck with a car loan that doesn’t fit in with your lifestyle, refinancing is one option to consider. If you choose this route, however, it’s important to remember that refinancing won’t automatically leave you better off.

To benefit as much as possible from your refinance, you should opt for a new loan with a lower rate and an equivalent or shorter repayment timeline if possible. That way, you’ll get the benefit of a lower rate without paying on your car loan longer.

If you have to extend the length of your loan to qualify for some reason, you can always continue paying the same amount you paid before — with the peace of mind that you could make a smaller payment one month if money gets tight. As long as your new loan doesn’t come with prepayment penalties, you can pay it off as quickly as you want – and still save money on interest along the way.

The Bottom Line

Refinancing an auto loan can be a smart move in certain situations, but other times, it might only extend the pain. Make sure to run the numbers and consider both your short-term and long-term financial goals before you get tied up in yet another loan you’ll have to pay off.

It might also pay to ask yourself why you keep borrowing money in the first place. If all you need is basic transportation, buying a used car and paying in cash might leave you wealthier in the long run.

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Have you ever refinanced an auto loan? How much do you owe on your car, and what is your monthly payment? 

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