Americans are in a love-hate relationship with their car loans.
More than half of new car loans are at least six years long, according to the most recent data from vehicle shopping guide Edmunds. Longer loan terms means lower monthly costs but higher total interest payments.
Refinancing is one way for consumers to make an auto loan more affordable. Knowing when to refinance, and how much could be saved by doing so, are essential to making a sound decision.
When it makes sense
Two scenarios that make the most sense for auto-loan refinancing are when interest rates go down or when a borrower’s credit score goes up.
If interest rates fall below where they were when the car loan was signed, refinancing opens up the possibility of a lower rate, which typically means the vehicle owner spends fewer dollars on interest.
“A common scenario where refinancing can make sense is when interest rates in the market have declined since the loan was taken out,” said H. Jack Miller, CEO of lender Gelt Financial. “Even a small rate reduction could save borrowers hundreds or even thousands over the life of the loan.”
While interest rates tend to be the focus - because they dictate monthly payments and lifetime cost of the loan - don’t forget about credit scores.
Credit scores have an impact on interest rates, said certified financial planner Eric Croak, president of financial firm Croak Capital. His general advice: Refinance when your credit score reaches at least 50 points higher than when you signed for the auto loan.
“Most lenders will agree that 50 is the tipping point to where better rates become available to you,” Croak told The Independent in an email.
A better credit score could put the borrower in a lower-risk credit tier, making them eligible for lower interest rates. Even a rate around two percentage points lower could save thousands in interest.
“If you carried a $25,000 balance [and refinanced at just over 2 percent lower], that’s $1,500 to $2,000 saved over the life of the loan, depending on how much time was left on it,” Croak said.
When it doesn’t make sense
Refinancing an auto loan doesn’t make much sense when the long-term savings don’t warrant it.
In some cases, lenders will charge fees to process a refinance and tack on other costs that could potentially negate any savings from a lower interest rate, Miller said.
“It is crucial to look at the total numbers when considering refinancing, rather than just looking at the new rate or monthly payment,” he said. “Fees or months tacked on could be disadvantageous.”
At the beginning of an auto loan there is a process called “amortization,” in which initial payments are mostly made up of interest. Over time, more of the payment goes toward the original loan amount (or the “principal”).
Because of this, it doesn’t make sense to refinance when an existing auto loan is in its final two years of payments, Croak said.
“If you’re in the last 24 months of your loan, it makes almost zero financial sense to refinance,” he said. “Quite frankly, I believe most people overlook this timing. By this point in your loan, your payment is heavily driven by principal, so a lower rate won’t save you much.”
Serious savings
Experts told The Independent that even a small change in interest rate could save the borrower hundreds or thousands of dollars over the life of the loan.
Say a borrower obtained a seven-year, $44,000 car loan (the average new-car loan amount) with a 10 percent interest rate.
Three years into the loan, the borrower opts to refinance the remaining balance with a four-year loan at 7 percent.
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Here’s what those numbers would look like, according to Calculator.net’s refinance calculator:
- Refinancing from a 10 percent auto loan with four years left to a 7 percent, four-year loan: $1,957.97 saved in interest, monthly payments drop by $40.79
- Shortening the term to three years: $3,047.90 in interest saved, monthly payments increase by $158.82
- Extending the refinance term to five years: $844.78 saved in interest, monthly payments drop by $160.17
When refinancing an existing auto loan, borrowers should run multiple scenarios with longer and shorter repayment terms. The best path is the option that balances a monthly payment within your budget and significant interest savings.
This article is sponsored by Credit Karma. We may earn a commission if you engage with their services using links in this article.
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