You bought a new car and financed it through a reputable lender, and you’ve been driving happily ever since. Why would you subject yourself to the headache and time-consuming details of applying for a car loan all over again? There would have to be something in it for you, and there can be. You might be able to lower your monthly payment. Changing the terms of your auto loan and snipping away at the interest rate you’re paying can reduce your car payments.
What Is Refinancing?
Refinancing is the process of replacing your existing car loan with a new one. Your new lender will pay off the balance of your current loan, so you’re effectively borrowing that money all over again under the terms of a brand-new loan. You’re not escaping your original loan. You’re transferring it from Lender A to Lender B. Your car still acts as collateral for the new loan.
Read More: The Best Auto Loan Interest Rates for 2020
Why Refinance Your Car Loan?
Those car payments you’ve been making are made up of two components: principal and interest. The principal portion involves repaying the money the lender gave you to buy the car. The interest portion is where the lender makes money. In simplest terms, you’re paying a little extra each month based on a percentage of your outstanding loan balance in exchange for the lender’s courtesy and kindness in fronting you the money.
How much you’ll pay in interest is based on the prime rate at the time you took out the loan, as well as your credit score. And you’re typically locked in for the life of the loan, although what you actually pay in interest each month will gradually decrease along with your outstanding loan balance as you make payments and reduce the principal. You’re paying a percentage of a smaller balance.
Refinancing your loan can relieve you of a hefty interest rate, maybe because loan rates have dropped since you took out the loan, because your credit score has improved or both. Maybe Lender A was charging you eight percent. Lender B is willing to give you a loan for just four percent under these changed circumstances. That might save you up to $75 a month or so, which works out to about $900 a year – thousands of dollars over the life of the loan. This could be a lifesaver if your income has dropped for some reason, and you can probably find more enjoyable places to put your money even if it hasn’t.
Read More: What Is the Purpose of Refinancing?
Stretching Out Your Loan Term
You might be able to lower your car payment even more by tweaking that first component of your payment – the principal portion. You could be tempted to stretch to a longer term for your refinance loan. But this can be tricky.
Let’s say you borrowed $25,000 to purchase your car after making a down payment. The length of the loan is 60 months, or five years. You’d be making monthly principal payments of about $417, or $25,000 divided by 60.
Now fast forward a year. You've paid off about $5,000 in principal. Your car loan balance is now $20,000. Your credit is much better than it was a year ago, and interest rates have dropped. You decide to refinance, and you take your new loan for five years as well.
The principal part of your car payment would drop to just $333 a month: $20,000 divided by 60. That’s a savings of $84 a month even before you take that reduced interest rate into consideration. How can that be a bad thing? Because you’re now paying interest over a period of six years rather than the initial five. You made one year of payments on your first loan, then rolled the balance over into a new five-year loan. You’re effectively making an extra year’s worth of interest payments.
How to Get a Refinance Loan
Taking out a refinance loan is no different than getting your old loan, except you won’t have the assistance of a car dealership. Dealers take care of the pesky detail of getting you financing in most cases, particularly when you’re buying a new car from them.
You’ll have to do the legwork yourself if you refinance. Start by gathering up your pertinent information: the balance you owe on your current car loan so you know how much you have to borrow and the interest rate to make sure you get a better one so refinancing is in your best interest. You’ll need all pertinent information about your vehicle as well: vehicle identification number (VIN), make, model, mileage and age. Some lenders won’t refinance older vehicles or those with a lot of mileage.
Inquire about the terms offered by various lenders when you’re armed with all this information. Don’t overlook the financial institution where you hold your personal finances. You might do well there because you already have an existing relationship with them. You might want to look into online banks and lenders as well.
Keep in mind that you probably won’t be quoted a firm interest rate before they’ve checked your credit, but you should be able to get a ballpark figure, as well as information regarding any other fees that might apply. The idea is to compare their terms and zero in on the best deal.
Getting a refinance loan is basically just a matter of applying for a new loan. The process is the same. You'll complete an application, have your credit checked and have your income verified. The lender will take over from here, taking care of paying off your current auto loan when you’ve been approved.
Some Words of Caution
Check your existing car loan for any prepayment penalties before you wade into the refinancing process. Not all auto lenders charge them, but it will take a bite out of any savings you might realize if yours does. You’d have to pay a fee when your loan is paid off early by the new lender because your existing bank was counting on having that income from you for the full term of your loan.
There might also be processing fees charged by your new lender for the courtesy of refinancing your existing loan. You’ll want to take this factor into consideration, too, when you’re comparing lenders and loans. These upfront fees will also affect how much you’ll save overall by refinancing.
Finally, your credit will probably take a little bit of a ding, just as it would if you applied for or took out any other type of new loan. Your potential lender will make a hard inquiry into your credit to qualify you for the refinance loan and this typically drags your score down a bit, as does taking on any additional debt. But all those separate inquiries should only count as one if you make numerous applications within 45 days or so. It’s apparent that you’re loan shopping, so all those separate inquiries should only count as one. You’re not going to be taking out a loan with each and every one of those lenders who inquired about your credit history and score.
- Bank of America: Is Car Loan Refinancing Right for You?
- Navy Federal Credit Union: How to Refinance a Car Loan
- Experian: Here’s What to Know About Refinancing a Car Loan
- Bankrate: When to Refinance Your Car Loan
- Board of Governors of the Federal Reserve System. "A Consumer's Guide to Mortgage Refinancings." Accessed Aug. 20, 2020.
- Consumer Financial Protection Bureau. "What Is a Balloon Payment? When Is One Allowed?" Accessed Aug. 20, 2020.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.