Auto loan interest rates have dropped to their lowest level since 2013. Does that mean it’s time to refinance your auto loan if you originally financed it at a higher rate?
But it may not make sense in some cases, and you may not be able to find a lower rate if you don’t do it soon enough.
What is Auto Loan Refinancing?
Replacing your existing loan with a new one from a different lender is what it means to refinance a loan.
The main reason to refinance is to get a lower interest rate, which gives you a lower monthly payment on the new loan.
The first loan is paid off and you then make loan payments (hopefully lower than the first loan) to the new lender.
But why not just ask your current lender to lower your rate? You could try, but even if interest rates have dropped substantially, a lender is unlikely to refinance an existing auto loan because you’ve already agreed to a contract for the rate you’re already paying.
Your car is collateral on the loan, so if you don’t make payments, the lender can repossess the car.
Refinancing is easy. Most auto loans don’t have a prepayment penalty, so it won’t cost extra to pay off the loan early. Also, auto loan applications don’t have application fees. The money from a new loan can often be available within a day.
Lower Interest Rates Are Biggest Reason To Refinance
Low interest rates are likely to catch your eye, especially if you review the monthly bill from your lender.
Interest rates have been dropping for years, most notably as a way to try to get the economy rolling again. When rates are low, consumers are more likely to take out loans and buy things. Homes and autos are the biggest purchases for loans.
Some car dealers offer 0% financing for buyers with great credit, though it’s only offered for new cars. Edmunds reports that 24% of all new financed purchases in May were 0% finance offers.
For other new car buyers, the annual percentage rate (APR) averaged 4% in May, down from 6.1% a year ago. It’s the lowest average interest rate since August 2013, and the third lowest Edmunds has on record back to 2002.
If interest rates are lower now than when you first bought your car, then refinancing will likely lower your rate. The money saved could be used to pay off the loan sooner.
Has Your Credit Score Improved?
A big factor lenders use in determining interest rates for borrowers is their credit score. Chances are if it has been a few years since you took out an auto loan that your credit score has improved.
Bankrate shows how high average interest rates are by credit score for a new car:
781-850 credit score: 4.19%
661-780 credit score: 5.01%
601-660 credit score: 7.91%
501-600 credit score: 12.17%
If you can’t get a 0% loan on a new car, but still have a great credit score, you should still be able to get a low rate. Edmunds found that 47% of all financed purchases received an APR below 3% in May.
Paying your bills on time, including car loan payments, is the best way to improve your credit score the most. A significant improvement can be made in as little as one year.
Along with knowing your credit score, it pays to shop around for a loan. If you didn’t do both before shopping for a car, then you might have taken the dealership’s loan and they could have marked up the interest rate without you realizing it.
You Can’t Make The Payments
Buying a car can be an emotional experience. You may have spent too much on a car that you find out months later you can’t afford.
If you’re struggling to keep up with payments, then refinancing your car loan can make sense.
A lower interest rate will lower payments, but so will extending the loan term with a new loan. Instead of having three more years to pay off your car, extending it to five years will make the new payments a lot lower.
The obvious downside is that you’ll be paying more in interest overall and will be making car payments for a few more years. All of this could add up to paying more over the longterm than you would have with the original loan.
The Biggest Downside To Refinancing
A major problem with refinancing an auto loan is that your car is now a used car, and used car loan rates are higher than new car loans. They’re often twice as high.
Financing a new car had an average APR of 4% in May 2020. For a used car, the rate was 8.3%, according to Edmunds.
So now, instead of comparing your old rate (if it was a new car) to the lower new car rates of today, you have to compare it to the much higher used car loan rates. It’s apples and oranges, and the old oranges cost twice as much as the new apples.
Lower Interest Rates Don’t Mean Paying Less Interest
But let’s say that your new car interest rate was so high that even a used car rate today will save you money on car payments.
That’s great news, right?
Not so fast. Refinancing years later means you’ve already paid a lot of interest on the original loan, and now will restart paying more interest.
Most auto loans are amortizing loans. You’re paying a fixed monthly payment with interest costs built into the payment.
Most of the interest cost is paid at the beginning of the loan. The principal that’s paid increases over time.
If you refinance into a new loan, the higher interest costs are again paid at the beginning of the loan.
To get around this roadblock, the simplest solution is to refinance the loan sooner so you can cut interest costs faster. An amortization table can show you how much you’ll save by refinancing.
But Can You Refinance A Used Car?
Waiting too long to refinance can leave you with few options. As we explained earlier, rates on new cars are typically lowest, so refinancing to a used car loan may not save you money anyway.
Some lenders won’t refinance cars that are more than seven years old. Older cars are deemed too much of a risk for breaking down, which gives you little reason to pay off a loan.
A new loan, especially one for a longer term, could put your car loan upside down. This means you owe more than what the car is worth. If your car is totaled in an accident, you’d be obligated to keep making payments on the loan until it’s paid off. Who wants to do that?
To get a “new car” rate you’d have to refinance your original loan immediately after buying from the dealer and taking advantage of dealer incentives.