5 Tips for Refinancing an Auto Loan

Auto financing is an aspect of the car-buying process where you can spend a lot of money unnecessarily... or save a lot of money if you do things right. If you get a car loan with a high interest rate, it can cost you an arm and a leg. But a possible solution awaits. You might be able to refinance the car. That will enable you to ditch the high-interest car loan that is bringing you down and replace it with a lower-interest loan that could lower your monthly payments by a significant margin.

Yes, it sounds too good to be true, but it is not magic, and it happens every day. However, before you get too excited about car loan refinancing, you should know that not everyone qualifies for refinancing. After some investigation, many people will discover that the car loan they have is as good as they are going to get. That said, if you think you are paying too much for your car, there is every reason in the world to consider refinancing.

The first step in the process is to understand how a car loan works and what it is. Typically, an auto loan is an installment loan that is repaid in monthly increments. Each monthly payment consists of two parts — the principal payment and the interest payment — although they are almost universally combined into one standard amount due each month. The principal is the amount borrowed, so the portion that goes to principal lessens the amount the consumer must pay back. The interest is essentially the fee the finance company charges the consumer for the use of its money.

When a car loan is issued, the finance company writes a check to the dealer for an amount of money to help you pay for your new ride. Over the length of the loan, you pay the financial institution that same amount of money plus interest. It is the size of this interest payment that can make the car buyer a candidate for refinancing the car loan or not. All other things being equal, the higher that rate of interest, the more likely it is that a loan refinance will save the car buyer money.

When someone refinances their car loan, they are replacing their original car loan with a new car loan. That is the distinguishing factor that separates “car loan refinancing” from “car loan modification.” The latter is a formal agreement between the finance company and the borrower that changes the existing agreement between them. It typically occurs when a borrower runs into financial difficulty but wants to keep the vehicle. In that situation, the borrower asks the lender to change the terms of the loan to make it possible for the borrower to continue making payments. The loan terms that might be altered are the interest rate, monthly payment, and length of the payback period. At the same time, the loan remains with the original lender. In a typical refinance, the consumer takes out a new loan to pay off the old loan. The terms of that new loan are more favorable than those of the old loan.

The first thing you need to do if you think you might be a candidate for refinancing is to look closely at the terms of your current loan. You want to examine not only the monthly payment, but also the interest rate you are being charged and the length of time left on your loan before it's paid off. These pieces of information will help you determine if a refinance will be right for you. Most importantly, you need to also find out if the terms of your loan include a prepayment penalty. If there is a penalty, how much is it? Depending on the if there's a prepayment penalty or not, a loan refinance might be a good move... or it might do nothing for you.

The easiest way to determine if your loan carries a prepayment penalty is to call your finance company. You need to ask them about a prepayment penalty and its size. You also need to know the total balance left on your loan. That information will guide you as you determine if a refinance will benefit you.

Before you try to refinance your car loan, it is very advantageous to know your current credit score. Prime candidates for successful car loan refinancing are those whose credit situation has improved since they were granted their car loan. With better credit than before, they are more likely to qualify for a lower interest rate on the new loan than on the existing loan. On the other hand, those who apply for a loan modification or loan restructuring are often in a poorer financial position than they were when they got the car loan. If you believe your financial situation has improved — you’ve gotten a better job, a raise in salary, or you’ve paid off credit card debt — it should be reflected in your credit score. You can learn your credit score for free by obtaining it from one of the major credit reporting companies — TransUnion, Equifax, and Experian.

Another important step in the refinancing process is determining the value of the vehicle you’d like to refinance. This number is different from the payoff amount on the car loan and the “residual value” written into the car loan contract. You might get good news or bad news when you learn the current value of your vehicle. If the value of the car is less than the amount you owe on the existing loan, you will find it difficult to refinance the car loan, and the process probably won’t be advantageous to you. The car is the collateral for the new car loan, and typically a lender will not allow you to finance an amount greater than it is worth. If, on the other hand, the value of your current car is higher than the amount you owe to pay back the loan including any pre-payment penalty, you are a prime candidate for a successful refinance. A lender should be happy to make a loan for less than the car’s current value since the car is collateral securing the loan.

Once your research gives you a positive indication that refinancing your car loan will save you money, begin shopping for a car loan. You can do this in the same way you would shop for a car loan to buy a used car. In this instance, you have the advantage of knowing the exact car you will be financing. And you know the terms of your current loan — the monthly payment, the interest rate, and the remaining payments you must make before you own the car free and clear. Be thorough in your shopping. Look at online loan sources and lending clearing houses. And don’t forget traditional sources like your bank and local credit unions. With some research, you should be able to determine quickly if you can obtain a loan that will enable you to pay off your current loan and move forward in a manner that will be financially advantageous.

As you determine the value of refinancing your car loan, it might be very tempting to obtain a loan for a much longer period than the time you have remaining on the current loan. That should result in a lower monthly payment than you had with the previous loan. While that’s appealing, if you do it, you are very likely to pay more in total interest on the two loans. From a prudent financial point of view, it is sensible to get a new loan for about the same period of time as the previous loan had yet to run. So if you refinance a five-year loan after two years, look to obtain a three-year loan, not another five-year loan. Doing that is likely to save you hundreds of dollars in interest. Of course, you should also look for a lower interest rate and a lower monthly payment from the new loan. If you don’t achieve that in your search, a car loan refinance won’t work for you.

When you are convinced that a new loan will be financially advantageous to you, close on the loan. Then use the proceeds of the new loan to pay off the old loan in full. The finance institution making the new loan might help you with this. In fact, it might pay off the old loan directly. As the transition from the old loan to the new loan is made, reach out to the finance company that funded the original loan to make sure the loan has been paid off fully. You will want to stop your monthly payments to that lender, but don’t do so until you have the official word that the loan has been paid off. Once that happens, you can look forward to paying a series of monthly payments that are lower than before. That’s the mark of a successful car loan refinance deal.