While many homeowners don’t hesitate to use their home equity strategically (i.e. through a “cash out” mortgage finance), fewer consumers are aware that you can do the same with your car loan. Refinancing a car loan works in much the same was as a home mortgage refinance—you pay off your previous loan in full and take out a new loan on your car at a different interest rate and/or a different loan term. In some cases, an auto loan refinance can save you money—but like with all loan instruments, refinancing a car loan can also have costly consequences.
Who should refinance?
There are two good reasons to refinance your car loan: to lower your monthly payments and to pay less in total loan payments. As a general rule of thumb, one or both of these can be achieved by refinancing for an auto loan with an interest rate at least 1 percent lower than your current interest rate. If your credit score has recently improved, the federal interest rate has dropped or if you got your car loan from the dealer at an exorbitant markup, you can likely get a lower interest rate just by shopping around. Your monthly payment and total cost of the loan will depend on the loan term that you choose. You can extend your loan term to lower your monthly payment, but you’ll pay more in the long run if you do.
Who shouldn’t refinance?
When consumers refinance auto loans, it’s best to do so strategically, rather than out of desperation. While some lenders offer “cash out” refinances for car loans, these can be much more dangerous than a home mortgage cash out refinance. That’s because unlike homes, cars always depreciate in value, meaning you can quickly wind up upside down or underwater on your car loan (i.e. owing more than your car is worth). This is bad news if your car is stolen or totaled, since your insurance company won’t pay out more than the car is worth. In the end, you could end up paying off a car that you don’t even own anymore.
In some cases, it is more cost-effective to refinance your car loan by modestly extending your loan term and/or negotiating a lower interest rate when compared to high interest cash advances or consumer loans. But those who signed up for artificially inflated car loans from the dealer or have significantly improved their credit scores will get the most benefit from refinancing. If you don’t meet these conditions, you should proceed cautiously when exploring refinancing and pay heavy consideration to the long-term costs of your new car loan.