Refinancing your car loan can be a big decision. You may be able to lower your interest rate and save money. However, in many cases, a new loan may cost you even more than the original. Here are a few of the pros and cons of refinancing a car to help you decide if it is the right decision for you.
What is Loan Refinancing?
Simply put, loan refinancing is replacing one loan for another. When you refinance, you are essentially paying off your old loan with money from your new loan, then repaying the latter under new terms. There are several reasons you may choose to refinance depending on your personal circumstances and motivations. Typically, borrowers look to refinance their car if they believe they can receive a new loan with more favorable terms or they need to increase their immediate cash flow.
Lower Interest Rate
One of the most common – and financially beneficial – reasons to refinance your car loan is to reduce your interest rates. Interest rates can fluctuate depending on the market, so choosing to refinance your loan may simply come down to the fact that rates have lowered.
But the current market isn’t the only factor affecting interest rates. An important component lenders consider when calculating the interest rate they offer is the borrower’s credit score. This number helps financial institutions determine how likely you are to pay the loan back. Therefore, if you had a poor credit score when you took out your initial loan, your loan had a higher interest rate. Conversely, if your credit score has improved since then, you may qualify for a lower interest rate.
If your financial situation has changed since you took out your original car loan and you are looking to lower your recurring expenses, refinancing could prove to be a good option. In this situation, a lender would offer you a new loan with lower monthly payments over an extended duration. Essentially, you would be paying less money each month but over a longer timespan. The downside of this, however, is that by extending the loan, the total amount you pay over the lifetime of the loan will increase (more on that below).
Increased Cash Flow
If you are in immediate need of cash, such as for a sudden home improvement need, a cash-out loan is also an option. This refinance option works if you currently owe less than what your vehicle is worth. You can then take out a new loan based on the equity of your car and pocket the money left over. For example, if your car is currently worth $12,000 and you owe $8,000, you have $4,000 in equity. A new loan would allow you to pocket the equity you have in your car.
There are some downsides to this option. Cars, unlike houses, are deprecating assets. Even if maintained well, a car will continue to lose value the longer you have it. This creates a possible pitfall of having an upside-down loan in which you owe more than what the car is worth. If you are involved in a crash that damages the car, the value will likely decrease drastically, making even more likely that you go underwater on your loan.
Another consideration with cash-out loans is that interest rates tend to be much higher than with traditional car refinance loans. You’ll want to ensure that the total interest you will pay on the loan is less than the cash-out you receive.
Increase in Total Cost
If you need to lower your monthly costs, refinancing is a great place to start. However, this option will likely extend the terms of your current loan and cost you more in the long run.
If you are extending the length of your loan, you will end up paying more over the life of that loan because interest will continue to be charged until the debt is fully paid. For example, if you have an $8,000 loan with a five percent interest rate paid over four years, you’ll pay a total interest rate of $843.25. If you extend your loan to six years, you will end up paying $1,276.44 in interest.
This may not be a problem if you are expecting to be in a better financial situation in the future or simply need a short-term influx of cash.
Always do the math on any loan you take out to make sure you are saving money.
Higher Interest Rates
There’s no guarantee that you will be able to secure a lower interest rate when you refinance your car loan, particularly if you are refinancing in order to lower monthly payments or receive a cash-out loan. Because of this, you should review your auto loan at least annually to see if you can secure an interest rate lower than what you currently have. If you see a lower rate you may want to jump at the opportunity, even if you weren’t considering a refinance before. It’s better to get a good deal when you can rather than a bad deal when you need it.
You will also be susceptible to higher interest rates if you have an older car. Most lenders won’t issue a loan on an asset that has significantly depreciated in value. If they do, to make the deal financially viable, they will charge a higher interest rate.
Looking to refinance? AAA auto refinancing offers loans with rock-bottom interest rates. Learn more.