How Does Refinancing a Car Work?

Are you looking for ways to lower your debt and reduce how much you have to pay in interest? If you drive a car and have an auto loan, refinancing is one option that may be available to you. 

Today, we’re here to answer the questions: What does refinancing a car mean, and how does refinancing a car work? 

We’ll cover everything you need to know about the topic so that you have a better idea of how refinancing works and how it may apply to your financial situation. 

What does refinancing a car mean? 

Refinancing, from the most basic perspective, means securing a lower interest rate. It’s possible for you to refinance a variety of lending options that come with an interest rate. These can include things like student loans, personal loans, mortgages, credit cards and car loans. 

If you borrowed money to buy your car, you have a loan with a lender. Your loan has a few different components that influence how much you’ll pay overall, including: 

• The principal balance, or the amount that you needed to borrow

• The interest rate, or the amount you pay on top of the principal in exchange for being able to borrow the money — this is also called the annual percentage rate (APR) 

• The loan term, or how long you have to repay the loan 

Let’s say, for instance, that you took out a $25,000 loan at a 4% interest rate. The life of the loan is 60 months. Your monthly payment is $460. Over the course of 60 months, you will pay $27,625. This means that you will pay $2,625 in interest. 

If you decide to do an auto loan refinance, you will secure better terms than your current loan — otherwise, there would be no point of refinancing. Your loan term may be shorter, and because of the lower interest rate, your monthly car payments will be lower. 

The point of refinancing is to save you money on interest. But there are scenarios where the lower interest rate could actually end up costing you more money, like if you extend your loan term. We’ll touch on that more below.

To better understand the impact that an interest rate can have, let’s use the same $25,000 loan we looked at above. However, instead of a 4% interest rate, you’re able to secure a loan with a 3% interest rate. Your monthly payment drops to $449. Over the course of 60 months, you end up paying $26,953. You pay $1,953 in interest. The lower rate ended up saving you nearly $700. 

The above example only shows the impact that interest can have on your loan. If you do choose to refinance, you will likely have already made payments toward the original loan amount. Your new loan will not reflect the same principal balance as your current auto loan. Let’s take a closer look at the process of refinancing a car. 

How does refinancing a car work? 

If you’re thinking about auto loan refinancing, there are typically two options available: You can negotiate with your current lender for a lower rate on your existing loan, or you can find a new lender and take out a new loan. 

Your first option would be to ask your original lender whether refinancing is an option. Auto lenders may be willing to refinance to remain competitive. 

If you pay your current car loan off early, the lender ends up missing out on interest payments. They may be willing to lower your rate if it means keeping you as a borrower. If you have a strong repayment history — meaning you’ve consistently made on-time loan payments — your lender may be more willing to work with you. 

The other option you have is to take out a new auto loan with a different financial institution. The loan will ideally be for the total amount you have remaining on your first car loan. 

Going back to our example above, let’s say that you have paid off half of the principal in 30 months. That means you have a $12,500 principal loan balance remaining with a 4% interest rate. If your lender isn’t willing to negotiate to lower the rate, you find a new lender who is willing to extend you a loan for $12,500 at a 3% interest rate. You use the new loan to pay off the principal on the original loan and close that loan out. Then you resume making your monthly payments, albeit to a different lender. 

What should I look for when refinancing? 

Now that we have answered how refinancing a car works, you’re likely asking yourself, “Should I refinance my car?” There is no cookie-cutter answer to that question. The answer will depend on your personal financial situation and numerous other factors. 

Below is a list of considerations when determining whether refinancing is right for you. 

The terms and conditions of your existing loan 

If you read the terms and conditions on your auto loan, there will likely be language discussing when you can pay off your loan. Lenders don’t want you paying off the loan too early, otherwise they’re not able to collect interest. 

One of the things you need to check for is a prepayment penalty. This is a penalty that your lender has in place to prevent you from paying off your loan early. It’s likely based on the length of your loan. 

For example, you may not be able to pay off the balance of your loan until halfway through your term length. This would be 30 months, based on our original example. 

Your lender may also include language in the terms and conditions based on the type of car you have. For instance, you may be able to refinance if you purchased a new car but not if you purchased a used car. 

These terms and conditions will be unique to your specific loan. You’ll need to do a bit of digging to find out what the potential penalties would be for refinancing. There are auto loan calculators that can help you determine the true cost of prepayment. 

Your credit score and report 

If you take out a new loan, your new potential lender is going to have to perform a hard credit inquiry on your account. This inquiry may be worth it if it means getting a better interest rate, but remember to be cognizant of timing. 

A hard inquiry will show up on your credit report and lower your credit score. If you make on-time payments in full, you should be able to overcome the slight dip in your score caused by the inquiry. 

Having said that, try to be mindful of when you request the refinanced loan. For instance, if you know that you have a large purchase looming — like a new home — you may want your credit score to be as high as possible. 

Also, as a general note, remember that lenders offer the best rates to those with the best credit scores. The higher your credit score, the more a lender will trust you to repay borrowed money on time. If you have a bad credit score, you may want to work on building your credit before searching for new auto loan rates. 

Your term length 

When going through the refinancing process, it’s easy to focus on the fact that you have a lower monthly payment with your new loan. However, you also need to be mindful of your new loan term. If you have a longer term with your new loan than you did with your old loan, your total interest payment may actually increase. 

This phenomenon is more common than you think — 35% of Americans say that they pick an auto loan based on the monthly payment cost. 

Let’s use our example above. You have paid off half of your current loan. You have $12,500 principal outstanding to be paid over 30 months with a 4% interest rate. Your monthly payment is $460. You have roughly $1,300 remaining in interest.

Now, let’s say you refinance to a 3.75% interest rate. However, instead of keeping the original 30 months that you had remaining, your new lender offers a longer loan term of 80 months. Your monthly payment is drastically lower, as you pay only $177 per month. 

However, your total will be $14,147. You actually pay about $350 more in interest, even though your monthly payment decreased by nearly $300. Be sure to crunch the numbers to find out the true cost of the loan before you refinance. 

Refinancing might help you pay off debt 

If you have an auto loan, it may be worth your time to consider refinancing. You can do so by either negotiating with your current lender or taking out a new loan with a lower interest rate. When you do, be mindful of how refinancing will impact your credit score, your monthly payment and your overall payment. 

Refinancing is one way to pay down debt, but it’s not the only way. If you are looking for more financial tips and insights, be sure to sign up for Tally’s free newsletter.