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The right time to refinance your car loan depends on a few different factors, including your credit score, the current car loan interest rates, and your general financial situation. But it's not always a good idea to refinance your car loan. If you think your car payment or interest rate is too high, here are some things to consider before you apply for a new loan to pay off your old one.
When to Consider Refinancing Your Auto Loan
There are a few instances when you might want to consider refinancing your auto loan. Here's how to know if your situation is right.
- Your credit score has improved. If you were given a relatively high interest rate on your current auto loan due to a low credit score, an improved credit history might help you score a lower interest rate on a refinance loan. Avoid applying too early, though. If you think your credit score will improve even more over the next few months, consider waiting until it's higher to get the best terms possible.
- Interest rates are dropping. Auto loan rates can rise and fall, depending on several economic factors. When rates are on the decline, you may have an opportunity to save some money with a refinance loan.
- You're at risk of default. If you're struggling to get by and don't want to lose your car to repossession, reducing your car payment could give you the breathing room you need. Even if you don't qualify for a lower interest rate, you may be able to get a lower monthly payment by applying for a refinance loan with a longer term.
When Refinancing Might Be a Bad Idea
While refinancing your car loan can have a positive impact on your finances, there are some pitfalls to watch out for.
- Your loan has a prepayment penalty. A prepayment penalty can kick in if you pay off your loan in full before it's due. While this fee isn't too common among major car lenders, it does exist. If your loan documents show a prepayment penalty, refinancing likely won't make sense if the savings you get from the loan switch don't exceed the cost of the penalty.
- You want to extend the loan term. While this strategy can be helpful if the alternative is defaulting on the loan and losing your car, it's generally not a good idea if you can afford the payments you currently have. That's because if you replace your current loan with one that has a longer repayment term, you will pay more in interest over the life of the new loan—unless you can manage to pay it off early.
- You owe more than it's worth. If you're underwater on your car loan—meaning you owe more than the value of the vehicle—refinancing is still possible but not always a great idea. This is primarily because your original lender will require you to pay the difference (called negative equity) as a lump sum before considering the matter closed. If you don't have enough cash lying around, you'll have a difficult time making it work.
How to Refinance a Car
For the most part, refinancing a car loan is similar to getting a car loan for a new purchase. Start by doing your research on various lenders to get an idea of what terms are available and which offers you might qualify for.
With some lenders, you may be able to submit an application to get pre-qualified. This process typically doesn't affect your credit but can be valuable in helping you see what you qualify for based on your credit scores.
Once you have enough offers to compare, select the best one for you and submit an official application. The lender may require information on you, the car and your existing car loan. Provide this information as quickly as possible to make the process go smoothly.
If you get approved and you accept the terms the lender offers, finalize the loan by signing the paperwork. The lender will pay off your existing loan directly.
During this process, don't forget to continue making payments on your current loan until it's paid in full. The last thing you want is to have your credit dinged because your new lender didn't pay off the old loan in time.
How Refinancing Affects Credit Scores
Virtually every time you apply for a loan, the lender will run a hard inquiry on your credit report. According to FICO, this inquiry can knock as many as five points off your credit score temporarily.
Multiple hard credit inquiries can have a compounding negative effect on your credit scores, but if you apply for multiple auto loans within a short period—typically 14 days but sometimes longer—they'll all count as just one inquiry when calculating your credit scores and won't have a negative impact.
When the lender opens a new credit account in your name, it could affect your credit scores again because it reduces your average age of accounts, a factor that influences the length of your credit history.
In both cases, the potential negative impact on your credit is typically minimal and temporary. If you start missing payments on your new loan, however, it could have a bigger and longer-lasting impact on your scores.
Carefully Consider Your Options Before Refinancing
Refinancing your car loan can be a good idea in some situations, but not necessarily in others. If you're thinking about replacing your current loan, make sure you understand your reasons and options.
Start by checking your credit score to see whether you've made progress since you first got the loan. Then consider why you want to refinance and what potential drawbacks and costs are associated with the process. Then compare auto loans based on your credit score to determine whether refinancing can save you money or if it might end up making things worse.
There's no one-size-fits-all answer to whether refinancing is right for you, but following this process can help you come to the right conclusion.