The Pros And Cons Of Refinancing Your Car Loan

By Rebecca Lake. May 7th 2016

If you’re looking to get a better interest rate on your car loan or you want to lower your monthly car payment, you may consider refinancing. Refinancing simply means that you pay off your existing loan and take out a new one with different (and hopefully better) terms. Generally, you may be eligible for a refinancing if you have a good credit score and a solid payment history. However, while it may be a good idea to seek more favorable loan terms on your car loan, it’s important to weigh the advantages and disadvantages before doing so.

When Refinancing Makes Sense

Determining whether refinancing your car loan is a good financial decision depends on a number of factors including your current loan’s interest rate, the amount of equity you have in the vehicle, the amount of your monthly payment and your overall financial health. You also need to consider the short- and long-term financial benefits that refinancing can offer.

Pro #1: Money Savings

Ultimately, the primary advantage of refinancing your car loan is that it can save you money over the long-term in terms of the interest you pay. If interest rates have dropped since you took out your original loan or if your credit score has significantly improved, qualifying for a lower interest rate can potentially translate to big savings. You can also extend the length of your loan to reduce your monthly payment if you need to free up room in your budget. For example, refinancing a four-year, $22,000 car loan into a new five-year loan at a lower rate can decrease your payment by as much as $100 a month. Reducing the same loan’s interest rate by just one percent could also save you several thousand dollars in interest over the life of the loan. You can then use the extra money you’re saving each month to pay down debts, fund your retirement accounts or save for a rainy day.

Pro #2: Cash-Out Option

If you’ve managed to build up some equity value while paying on your current loan, you may also be able to enjoy the benefit of a cash-out option if you choose to refinance. When creating the new loan agreement, your lender will base it on the vehicle’s current value. Typically, lenders will use guidelines established by the National Automobile Dealers Association (NADA) to determine your car’s worth. If the lender determines that your car is worth more than you owe, they will pay off the old loan and return the difference to you. Refinancing when you have equity in your vehicle can be appealing, especially if money is tight and you need extra cash.

Disadvantages Of Refinancing

While refinancing offers several advantages in terms of savings and possible cash back, it is not without its drawbacks. For example, you may be subject to a prepayment penalty for paying off your existing car loan early. In some cases, refinancing can actually end up costing you more money in the end.

Con #1: Negative Equity

Negative equity means that you owe more on your loan than the car is worth. Even if you have excellent credit, having negative equity can make it difficult to convince a lender to help you with a refinance since the new loan will only be partially secured. If you do find a lender that is willing to offer you a new loan, you may be able to lower your monthly payments by extending the loan but it’s unlikely that you’ll be able to secure a better interest rate. Your lender may also require you to pay the difference between the amount you’re borrowing and the amount your car is worth before approving the loan. If you’re not upside down on your current loan, refinancing can put you at risk for negative equity if the vehicle depreciates significantly prior to the end of the loan.

Con #2: Longer Repayment Period

While refinancing can help you to lower your monthly payment, it can also put you in the position of paying on your loan for a longer period which may not save you any money in the long run. If you’ve only been paying on the loan for a short period of time, chances are that most of your payments have gone to interest rather than principal. If you’ve already been paying on your loan for several years, you most likely have paid most of the interest off already. Refinancing too early or too late in the life of the loan is essentially the equivalent of starting over which can end up costing you more money in terms of the interest you’ll pay. Adding months or years to your existing loan term also keeps you in debt longer, which can prevent you from making progress on your other financial goals.

If you’re contemplating a car loan refinance, it’s important that you do your homework beforehand in order to make sure you’re getting the best deal available. You may want to talk to your current lender or contact banks and credit unions in your area about the possibility of refinancing. You can also search online to compare refinancing rates. Before you finalize any refinancing agreement, read the fine print carefully to make sure you’re not paying any unnecessary fees or agreeing to any terms you’re not comfortable with.

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