What is Refinancing an Auto Loan: All You Need To Know

What is Refinancing an Auto Loan

An auto loan is a type of loan taken out to finance the purchase of a car. The car is used as collateral for the loan, and the lender can seize the vehicle if the borrower fails to repay their monthly debt obligations.

Research published by Policy Advice indicates that in 2022 there will be roughly 36 million open auto loans totaling $1.2 trillion in auto loan debt. So, if you own a car, you probably have some form of an auto loan.

Now, many people who have an auto loan choose to refinance it at some point. Refinancing an auto loan means taking out a new loan with different terms to replace your existing auto loan.

There are many reasons why people refinance their auto loans, but the most common reason is to pay less on your loan amount.

According to Rategenius, refinancing car loans saved Americans an average of $1200 in 2021. In this article, we will discuss everything you need to know about what refinancing your auto loan can do for you.

What Is a Refinance, and How Does It Work? 

To understand refinancing, you first need to understand how financial institutions make money. Financial institutions provide loans to individuals and then charge you interest on that loan called APR (aka Annual Percentage Rate).

APR is a percentage of your remaining balance that gets added to your monthly payment. These rates change based on your credit score and market competition.

You can qualify for a better rate when you refinance a loan with a higher credit score. Similarly, if interest rates have lowered since you initially took out your loan, you can also qualify for a better rate.

Refinancing a loan means taking out a new loan from either the same financial institution or a new one to pay off your current loan.

There are multiple ways to refinance a loan, including reducing the interest rate, increasing the loan term, taking cash out of the loan, and a few other options.

Here’s An Example Of How Refinancing Can Help You

Let’s say Jim bought a used Mustang for $25,000 in January 2020. He put $5,000 down, making his total amount owed on the car $20,000.

His credit score at the time was 600, and Bank of America gave him a $20,000, 5-year loan with an APR of 15%.

This means that he would be paying around $475 a month for five years to pay off his car. If Jim never refinanced his car, he would have paid just over $35,000 for the car at the end of five years. That’s an additional $8,500 in just interest payments!

However, let’s look at a slightly different scenario. Jim buys the same car and puts the same amount down in this scenario. After two years, Jim maintained good payments on his credit cards, paid them off in full every month, and was on time for all his car payments.

At this point, the remaining balance on his loan is roughly $13,725, but his credit score has jumped from 600 to 750! His credit score now qualifies him for a lower interest rate!

He contacts a credit union looking to see what kind of loan they can offer him, and he finds out they would give him a 5% rate on a 3-year, $13,725 loan.

This means that he could get a monthly payment of $411 with no new down payment and still pay off his car in the same amount of time. The difference in interest rates would save him $64 a month.

So Jim, having understood refinancing, took out a no down payment loan from the credit union for the remaining $13,725 he owed Bank of America.

He immediately paid off his loan to the bank and now owes the credit union the rest of the balance at a monthly rate of $411. By the end of his loan, he saved a total of $2300 on interest payments! This is the power of refinancing!

Where To Get Your Loan Refinanced? 

Typically speaking, credit unions offer better interest rates than many banks. However, their websites are often antiqued and typically don’t have as many physical offices. 

It is important to remember that you should always assess multiple lenders when considering a refinance.

Whenever you find a great rate, use that as leverage in negotiations with other providers and see if they can offer a better one.

What Are Other Reasons To Consider Refinancing? 

Sometimes when you refinance, you aren’t just looking to lower your total interest payments. Sometimes, your goal may be to extend the life of your loan.

In Jim’s example, instead of taking out a 3-year loan from his credit union, he could take a 5-year loan. This means that instead of paying off his car in five years like he would have done initially, he will now pay it off in 7.

Assuming all else stays the same, he would now only be paying $259 a month for monthly payments rather than $475.

By increasing his loan terms by another two years, he would reduce his monthly payment by roughly $215! However, by extending his loan term, he would only save $1,590 instead of $2,300.

The reason for the difference is that he would be paying more in interest due to the longer loan duration.

This type of refinancing is favorable if you are having significant trouble paying off your auto loan and want a lower monthly payment.

Benefits To Increasing Your Loan Term 

That being said, there are some other reasons why you would want to refinance to a longer-term loan.

  1. Having a longer loan will mean having more opportunities to make payments toward your loan amount. If paid on time, your credit score will increase.
  2. You can cash out of your refinance by refinancing with a longer loan term. A cash-out refinance is where you borrow more from your new lender than you need to pay off your original loan. This will leave you with extra cash to help pay off any other debt or existing expenses.

Will Refinancing Affect My Credit Score? 

Credit scores are how financial institutions determine how much you can be trusted with being loaned money.

Taking out loans negatively affects your credit score but paying your loan back on time will help bring it back up. Usually, your score will only dip a few points and jump back up within a few months if you pay your loans on time.

Can I Use A Refinance To Improve My Credit? 

There are two types of credit: revolving and installment. Individuals with really high credit scores usually have a healthy mix of both. A credit card is an example of revolving credit.

Mortgages, auto loans, and business loans are types of installment credit. The difference between the two is that with revolving credit, your balance can continue to fluctuate (go up and down).

Whereas with installment credit, the loan is paid off in full once you make your final payment.

Lenders like to see both types of credit because it shows that you are good at managing different types of debt. However, if you only have one type of credit, they may be wary of loaning you money.

By increasing your auto loan term, you can increase your installment credit. Typically speaking, younger car owners do not have mortgages, making auto loans their first taste of installment credit.

Increasing your installment credit can drastically improve your credit score, allowing you to lock in better rates when you apply for a mortgage.

Refinancing In A Low Rate Market 

The auto loan market is similar to any other: if consumers are lining up to take loans, financial institutions can charge higher interest rates without losing business. 

On the other hand, if the economy is healthy and consumers have easy access to leverage, financial institutions will have to charge lower APR’s to remain competitive.

Even if you are happy with your loan payments, keeping an eye on market interest rates can save you money if a financial institution is willing to beat your rate. 

Are There Any Drawbacks To Refinancing? 

When refinancing a loan, it is always important to consider the sale value of what you are refinancing.

Most cars significantly depreciate over time, and taking out a new loan with a higher total value than the resale value of your car is a bad idea. This would be considered an underwater loan (also known as an upside-down loan).

For example, if your car is only worth $5,000, but you have a loan for $7,000, you have an underwater loan.

In this case, it would not make sense to refinance because you would be taking out a new loan with a higher value than what your car is currently worth. In this scenario, your focus should be on paying down the loan until it reaches the resale value of your car.

Another thing to remember is that some lenders will penalize you for refinancing your loan early. These penalties typically come in the form of higher interest rates or service fees.

Therefore, it is important to factor these into your decision to refinance so that you do not pay more in the long run.

Another drawback is that the savings might not be as significant as you originally thought. For example, if you only lower your interest rate by a percent or two, your monthly savings might not be enough to justify going through the refinancing process, which can take a few weeks.

Can I Take Money Out Of A Refinance? 

Earlier we talked about being able to take some cash out of a loan by borrowing more than what you owe. This technique is common in the real estate market.

However, auto loans typically don’t see too many good opportunities for cash-out refinances. Lenders will typically only allow you to cash out up to 125% of the original loan balance.

With a mortgage, this could potentially get you access to hundreds of thousands of dollars which can be used for home improvements, investments, or anything else.

However, with auto loans, the amount taken out of a refinance is typically not large enough to justify this method.

If you need to cash out in auto refinance to pay off other types of debt (like credit cards, personal loans, student loans), it may be best to reconsider your spending habits.

Other Factors To Consider When Applying For a Refinance 

When refinancing your car loan, it’s important to remember that your credit score will dip slightly when you first take out a loan because the lender will make a hard inquiry on your credit report.

It is also important to note that most lenders will require proof of income and employment when applying for a refinance. This is because they want to make sure that you can still afford the monthly payments on your loan.

If you are self-employed or do not have a traditional job, getting approved for a refinanced loan might be more difficult. In this case, you might need to provide additional documentation to prove your income.

Key Takeaways 

Refinancing an auto loan means taking out a new loan to pay off your existing car loan to get more favorable terms.

You should consider refinancing your auto loan if your credit has gone up, the market’s APRs have decreased, or if you want to extend your installment credit history.

Though your credit score will take a hit by taking out a new loan, it may be worth the trouble because it will bounce back and has the potential to increase depending on your payment habits.

Since most cars depreciate in value, refinancing an auto loan for an increased total loan is a bad idea since you should try to keep the loan value lower than the resale value of the car.

Make sure that you consider multiple lenders when researching refinancing auto loans, including different credit unions and banks.