Considering refinancing a car loan? Learn how to save on interest and payments. A guide to help you decide if refinancing is the right move for you.
Article, Infographic: 8 minutes
Updated: June 19, 2024 Published: June 19, 2024
By: Sean Scaturro, MBA, CFP® Reviewed by: Editorial contributors
Whether you’re trying to save money on your car payment or trying to secure a lower interest rate than your current loan rate, the decision to refinance your car loan requires some number crunching.
This guide will help walk you through the important points to consider before refinancing your auto loan.
There are a few major components that make up the terms of your car loan:
Loan amount is the total balance of your loan. This amount can include any fees or added costs above the sales price of your car. When you’re considering refinancing an existing car loan, your loan amount may include accrued interest.
You should request a 10-day payoff from your current lender to have an accurate amount for your new loan comparisons.
Loan term length is the number of scheduled years or months that the loan is scheduled to take until the loan amount is paid off.
This is the rate charged as a cost for your loan. The higher the rate, the more total interest you’ll pay over the life of your loan. Be sure to look at any loan offer’s annual percentage rate or APR. This is a more accurate number to use in comparisons as it includes the effect of fees or other costs in addition to the interest rate applied.
What you pay each month towards the balance of your loan. Your payment will have a portion of interest and principal, including things like fees or taxes that may have been part of your loan deal. You’ll pay more interest in your first year of the loan than in the remaining years.
Refinancing is when you get a new loan to pay off your existing car loan. The new loan should be at different loan terms resulting in a different payment amount. You may have a fee for the new loan acquisition from the bank. You may also have prepayment fees for ending your existing car loan sooner than anticipated. We’ll talk more about these fees later.
The general rule of thumb is to refinance when the new loan reduces the total amount of interest paid over your current loan. The appeal of a lower car payment can be attractive, especially when on a tight budget.
However, simply changing the loan length may reduce your payment but increase the total amount of interest you pay. Because vehicles typically depreciate, you should avoid extending the time until your vehicle is paid off to less than 6 additional months.
Every situation is unique, and refinancing could make sense for yours, so it’s important to know how to review the numbers.
Let’s look at a few examples:
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Your monthly payment is $660.49 for a total loan amount of $39,629.58. This loan costs $4,629.58 in interest charges over the life of the loan. With refinancing, the goal should be to reduce the interest costs or monthly payment and not increase the total loan cost dramatically.
Assume that you’ve been paying on this loan for a year and have a payoff balance of $28,680.57 remaining. You want to see what your payment would be if you refinanced on a new loan for 6 years or 72 months.
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Your new payment would drop to $461.90, freeing up about $200 a month in your budget. However, this scenario would cost you an additional $1553.02 in interest.
Key takeaway: extending the loan length may reduce your payment but may not reduce the total amount of interest you pay.
Let’s use the same scenario, but rather than changing the loan length, you refinance at a lower rate for the same remaining length of time. You refinance to reduce your rate to 3.5% and keep the same payoff schedule with a remaining 48 months.
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Your new payment is $641.18, saving nearly $20 per month. This scenario would save you $926.90 in interest costs compared to the original loan.
Key takeaway: Taking advantage of lower interest rates can have a big impact on the total interest costs of your loan.
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Assume that you refinance your remaining balance for 60 months at a new interest rate of 3.5%, your new payment is $521.75. In this scenario, you’ll have saved about $140 a month and almost $400 in total interest.
Key takeaway: If rates are lower today than when you first took out your loan, it may present an opportunity to save over the life of your loan.
You may be looking for ways to save and are considering refinancing for a lower payment but at a longer loan term. This could be a short-term gain on your monthly payment but a long-term cost in interest and potential loss of equity.
Ideally, you can sell your car for more than what you owe on it and can put that money towards a new car purchase in the future.
Cars typically depreciate. New cars lose the most value within the first year on the road. After five years, your new car may be worth 40% less than you purchased it for. You could see your loan balance exceed the value of your car. This is commonly called being “upside-down.”
Being upside-down in your current car can impact your future car purchases. It could also leave you in a tight spot financially if your car is stolen or totaled in an accident. Your bank or lienholder gets paid first in an insurance claim for a total loss. Unless you have things like GAP insurance or a car replacement benefit on your auto policy, you could be on the hook for the difference between your loan balance and insurance settlement amount.
It’s important to know all the details you can about your current loan and any loan offers you’re considering. While rare, your current loan may have a prepayment penalty for paying the loan off sooner than scheduled. Your new loan may have loan origination costs or other fees that are built in. Read through your loan documents and make sure to include any fees that you may have in your calculations.
According to research by Bankrate®, the average prepayment penalty is about 2% of the remaining loan balance. Revisiting the scenarios from this article, that could mean paying an additional $573 to refinance your car. Prepayment fees are only allowable in some states and are prohibited on longer term loans, so check your loan documents to see what you may or may not have.
Similarly, origination fees can range 1-2% of the total amount borrowed. In our scenario, that would add about $280-573 bucks if your new loan provider charges an origination fee.
There may also be optional programs, like warranties or insurance policies, wrapped into your loan that could be impacted if you refinance. Look out for things like credit life insurance and GAP protection. These programs typically provide benefits that are tied to the loan balance. If you want those programs on your new loan, speak to your new loan provider to see if they’re offered.
Crunch the numbers. If you can save money on both the total interest paid and your monthly payment, it may be a good idea to refinance. Saving money on your payment alone may not be ideal, whereas saving money on the total interest is preferred.
Do some research on rates, terms and get help from tools like USAA’s auto loan calculator. See note 1 Having numbers for refinancing can help you weigh out the options and help you make the best decision for your unique situation.
We put you in the driver’s seat, so you can choose the best options for your budget.
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