Has your credit score improved since you took out your first auto loan? Are you seeking a lower interest rate? Or do you just have a gut feeling that you can find a better deal with a new lender?
If you answered “yes!” to one or more of the above questions, refinancing your auto loan might be a smart money move. Put simply, refinancing an auto loan involves taking out a new loan to pay off your old loan and starting over with a new lender.
If you’re ready to explore the possibility of refinancing, you probably have a new set of questions:
- How can you determine that refinancing is right for you?
- Do you and your car qualify for refinancing?
- What documentation will you need to prep?
- How will refinancing affect your credit score?
- What are some common pitfalls to avoid when refinancing an auto loan?
I’ll answer these questions and more as I explore how to refinance your car loan in seven steps.
1. Check your credit score
Checking your credit score before taking out a loan is like checking your breath before a big date. It’s a small thing, yet it can determine the outcome of everything else.
Your credit score will determine the overall terms of your new loan just like your old one. Put simply, high scores (700+) translate to lower interest rates.
What’s most important, however, is whether your credit score has improved since you took out your first auto loan. If your credit score has gone from 640 to 700, refinancing almost certainly makes sense, since you’re likely to get a lower interest rate. However, if your credit score has dropped from 800 to 700, your new interest rate may even go up.
Thankfully, like swishing with Listerine, checking your credit score only takes about 30 seconds. Visit your online banking dashboard or Credit Karma – they’ll all show you your score for free.
If your credit score has remained steady or dropped a few points, it’s still worth taking steps two through four of this guide to at least get some rough quotes. If your score has plummeted over 100 points, that might be a sign it’s time to improve your credit score before taking on any more debt.
2. Determine whether refinancing is the right choice
A rise in your credit score since taking out your first loan is a good sign that refinancing makes sense. However, a jump in credit score isn’t the be-all and end-all.
What other factors should play a role in your decision to refinance your auto loan?
What are the terms of your existing loan?
Naturally, you’ll want to get a clear picture of your existing loan terms before you start cross-shopping. What is your interest rate? Is it fixed or variable? How much of your loan amount do you still have to pay off? How many months do you have to pay it off?
All in all, specifically what are you trying to get out of a new loan?
Tinker around with MU30’s handy Loan Payoff Calculator and see where the weak link is in your existing loan. Most commonly, folks are trying to lower their interest rate. In addition to lower interest, you may want a slightly longer loan term to lower your monthly payments (just don’t let your total interest paid get too out of control).
One quick note before I move on: if you got your financing directly from the dealer where you bought the car, you probably want to refinance. That’s because dealers aren’t known for offering customers the best financing deals (or even close to them). Dealers offer convenience, not savings. So it may be time to break up with your dealer/lender and find someone with a better rate.
In addition to basic details like your interest rate, term, and loan amount, there’s another important factor buried in your loan document that most folks tend to gloss over.
Does your lender have prepayment fees or penalties?
Perhaps the biggest “gotcha” in the refinancing world is prepayment penalties. Yep – your lender may charge you for paying off your loan too early.
If lenders charging fees to people who, you know, pay back their loans sounds ridiculous, it actually makes perfect sense. When you sign a loan document, you promise to pay back your lender the amount you borrowed plus interest. The interest not only protects your lender’s money from inflation, but it’s also their only source of profit.
So when you pay off your loan early, you’re withholding the interest you promised to pay. Call me a late-stage capitalist, but lenders are kinda entitled to that money. So they’ll try to recoup at least some of it in the form of prepayment penalties.
In your case, you’ll want to revisit your loan document and search for any prepayment penalties or fees. These can often be expressed as a percentage of the principal, interest, or total loan amount remaining, or a flat fee.
If your lender’s prepayment penalties are egregiously high, refinancing may not make sense. Either way, keep this fee in mind as we move forward.
Are you “underwater” on your loan?
Your next step is to compare your car’s resale value to the amount you have remaining on your loan. If you owe your lender more than the car is actually worth, you’re what’s known as “underwater” on your loan.
Why does being underwater matter if you’re not selling the car, just refinancing it?
Well, many lenders won’t refinance a car that’s underwater. The reason being, if you default on the loan, they can’t just repo and resell the car for the amount they’re entitled to. They’re taking on risk, so they’re unlikely to give you better loan terms (or a loan offer at all).
If you’re underwater on your loan, consider increasing your monthly payments or making a lump sum payment to get right-side-up. You can also talk to your current lenders to establish a new payment structure (because they don’t want you underwater, either).
