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A cash-out auto refinance replaces an existing car loan with a larger one and cashes out the difference to the borrower. If you have bad credit or your credit has gotten worse since you obtained the original loan, it may be challenging to qualify for one.
Auto lenders generally prefer borrowers who have good or excellent credit. A borrower refinancing to a new, larger loan causes a lender to take on more risk, which may cause them to be more discerning with an applicant's credit. You may need to work on your credit before you can qualify.
Here's what to know about cash-out auto refinance loans and what to do if you have bad credit.
What Is a Cash-Out Auto Refinance?
A cash-out auto refinance loan is similar to a cash-out refinance mortgage loan. If your financed vehicle is worth more than you owe on the loan, you may be able to refinance it with a different lender and gain access to some of the progress you've made in paying off the vehicle.
For example, if you have a $3,000 loan balance on a vehicle worth $5,000, you could potentially refinance your auto loan for up to $5,000. The first $3,000 will pay off your existing loan, and the rest can be disbursed to you in cash.
The amount of money you actually receive will be based on the amount of equity you have in your vehicle, the lender and your credit situation.
For example, some lenders may allow you to finance up to 100% of your vehicle's value, while others may have lower limits.
Not all auto lenders offer cash-out auto refinance loans, so you'll need to take the time to search for at least a few options that you can compare.
Do You Need a Good Credit Score for a Cash-Out Auto Refinance?
As with any type of loan, your credit score is an important factor to lenders. If you have bad credit, you'll generally have a harder time getting approved for credit, and may have to pay higher interest if you are. Cash-out auto refinance loans are no exception.
Auto loans almost always use the vehicle being financed as collateral. This means, in the event you stop making payments, lenders can repossess and sell the vehicle to recoup the outstanding balance on a loan. But cars tend to depreciate quickly, so this poses a challenge to lenders if a borrower owes close to or as much as the car is worth. If a car depreciates faster than you can pay down the balance, you may end up owing more than the vehicle is worth—a scenario lenders prefer to avoid.
Statistically, people with bad credit are more likely to miss payments or default on their loans than people with good credit, so lenders may deny your cash-out auto refinance application if your credit score is below a certain threshold.
What Are the Risks of a Cash-Out Auto Refinance?
Even if you can qualify for a cash-out auto refinance loan, you may not want to go through with one. Be sure to understand both the benefits and the drawbacks of this option before you make a decision. Here are some potential risks that could make your situation worse:
- It may increase your monthly payments. Depending on how much you take out in cash and your new repayment term, a cash-out auto refinance could make your new loan more expensive. If you have the budget for it, that may not be a problem. But if you're already just barely scraping by, it could make it even more difficult to keep up with payments.
- You may end up with negative equity. If you borrow 100% of your car's value, or close to it, the vehicle may end up being worth less than what you owe if it depreciates faster than you can pay down the debt. In this situation, you'd end up with negative equity, which is when you owe more than your vehicle is worth. If you choose to sell the car or it gets totaled, you may end up having to pay the difference to the lender in cash.
- You could lose your car. If your new monthly payments are so unmanageable that you miss payments and ultimately default on the loan, the lender will typically repossess the vehicle and sell it at auction.
- You likely have better borrowing options. There are many alternatives to a cash-out auto refinance that pose less risk and could cost you less in interest. Before you decide on a cash-out auto refinance, be sure to explore other options such as personal loans and 0% APR credit cards. These may be challenging to qualify for if your credit score is low, but are worth a look. Another option: borrowing from a friend or family member.
How to Improve Your Credit Before Applying for an Auto Refinance
If you're thinking of applying for a cash-out auto refinance with bad credit, you may want to reconsider. If you don't absolutely need the cash right now, think about working to improve your credit to make it easier to get approved and also save money on interest.
Here are some ways you can improve your credit score before you apply to refinance an auto loan with cash back:
- Focus on payments. The most important factor in your FICO® Score☉ is your payment history, so make it a goal to pay all your bills on time. If you have any accounts with past-due payments, get caught up quickly to avoid further damage to your credit score.
- Pay down credit card debt. Another influential component of your credit score is your credit utilization ratio, which measures the amount of credit you're using against your total credit limit. The lower your card balances are relative to their credit limits, the better it is for your credit score.
- Get added as an authorized user. If you have a loved one who has a credit card they've never missed a payment on, ask if they'll add you as an authorized user. If they do, the account history will appear on your credit reports, which can help improve your credit score.
- Avoid new debt unless necessary. Anytime you apply for credit, the lender is likely to run a hard inquiry, which can temporarily drop your credit score by a few points. Also, when you open a new credit account, it lowers the average age of your accounts, which impacts your length of credit history (another factor in your credit scores).
As you take these and other steps to improve your credit score, you'll have a better chance of getting approved for a cash-out auto refinance loan, as well as other loans.
Monitor Your Credit Regularly to Maintain a Good Credit Score
While it's important to work on your credit to improve your chances of getting favorable financing options, it's crucial that you continue to practice good credit habits to maintain that improved score.
You can do this by monitoring your credit with Experian. The platform offers free access to your FICO® Score and your Experian credit report, which is updated every 30 days. You'll also get real-time updates when there are changes to your Experian credit report, such as new accounts, inquiries and changes to your personal information.
As you build your credit score and continue to monitor it, you'll have a better idea of what's impacting your credit score, so you can address potential problems quickly.