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Refinancing your car—taking out a new loan that pays off and replaces your current auto loan—may cause a short-term drop in your credit score, but it can be well worth the tradeoff if it saves you enough money in the long term.
How Does Refinancing an Auto Loan Work?
Refinancing a car loan is fairly straightforward: You apply to lenders for a loan in the amount that remains on your current car loan. (Make sure you apply to multiple lenders to ensure you get the best deal.)
Compare the terms on all the loans you qualify for and pick the best one. Once you settle on a refinance lender, they contact the lender on your original auto loan, pay off the loan in full, and take over the lien on the car (the legal right to take possession of the car if you fail to make your payments).
When deciding which refinance lender to choose, your refinancing strategy should focus on at least one of these goals:
- Reducing the amount you pay over the lifetime of the loan. This mainly refers to interest rates. Refinancing at an interest rate lower by at least 1 percentage point than your current rate generally means appreciable savings over the life of a typical 48-month auto loan. Bear in mind, however, that the savings will vary depending on the number of payments left on your original loan, and that fees associated with the new loan may reduce overall savings. The process is often worth it, but you should calculate the total costs of each loan, taking fees into account, to make sure.
- Lowering your monthly payments to make them more manageable. If your household expenses have increased since you took out your car loan, or if you'd just like a little more breathing room in your monthly budget, you can use refinancing to adjust your monthly payments by extending your payback period by six months or more. Stretching out the loan payment terms typically increases the overall cost of the loan, but you may be able to offset at least part of that if you're able to take advantage of lower interest rates. Even if the total cost increases, however, it may be worth it to lower your monthly outlay, particularly if doing so ensures you're able to pay all your other bills on time.
How Refinancing a Car Can Temporarily Lower Your Credit Score
From the standpoint of credit scoring systems such as the FICO® Score* and VantageScore®, the effect on your credit score from car refinancing is the same you'll see anytime you apply for and take out a new loan: You'll typically see a small score dip when you apply for the loan, following the lender's request of a hard inquiry of your credit score, and an additional dip when your application is accepted and you take on the repayment obligation.
The reason for both these score dips is similar: Statistically speaking, when borrowers apply for new credit and take on additional debt, they are at greater risk of being able to pay their bills every month. After a few months of uninterrupted payments, credit scoring systems typically bring the scores back up to their former levels—and may even increase them a bit in recognition that the borrower has shown they can handle the new debt.
Two important considerations:
- Credit score reductions associated with hard inquiries are not compounded when you shop lenders for the best deal you can get. The FICO® Score and VantageScore systems treat applications for multiple loans in the same amount as a single event, as long as they take place within a span of a few weeks.
- The new-debt impact on a refinancing loan is minimal, because its appearance in your credit file will coincide with the closing of the old loan account, meaning there's no net increase in your outstanding debt.
How a Refinance Will Appear on Your Credit Report
When you complete the refinancing process, your new loan will appear on your credit report, and payments toward it will be duly noted (along with whether they were timely or late). Your original car loan will remain on your credit report as well, marked "closed in good standing," for up to a decade.
When Is It a Good Idea to Refinance a Car Loan?
It makes sense to refinance a car loan under the following circumstances:
- When your car is retaining its value. Before applying to refinance your loan, check with the Kelley Blue Book, Edmunds.com or the National Association of Auto Dealers (NADA) to determine your car's approximate resale value. If your car's age, high mileage, significant crashes or repairs, or other market conditions make it worth less than what you owe on it, refinancing is likely to prove difficult.
- When interest rates are dropping fast. If the price of borrowing money falls significantly, you may qualify for a new loan at a significantly lower rate than your original one. As of 2019, prevailing interest rates are trending slowly upward. Generally the time required for significant interest rate declines is a matter of several years, so this factor is much more relevant to refinancing mortgage loans (with repayment periods that span decades) than to car loans with typical terms of three to five years.
- When your credit score is rising fast. If you increase your credit score significantly in the 12 months or so after taking out a car loan, you may qualify for loan offers with better interest rates.
- When you need to reduce your monthly expenses. If you need to reduce your monthly expenses to better manage your finances, extending your car loan repayment may make sense, even if it means paying more over the course of the new loan.
Refinancing a car loan can be a fairly straightforward process. As long as you understand that it will mean a small, temporary ding to your credit score, the savings over the long haul could be well worth it.