Home loans and car loans have a key aspect in common. Both are considered “secured instruments” because they are backed by the property against which the loan is written. In other words, the lender holds the title to real estate and vehicles until the loans are paid off. If you default, they’ll seize the assets to mitigate their losses.
With that said, refinancing can free equity that may have accrued in both cases. While this is more likely in real estate than automobiles, it can make refinancing a smart decision.
So, when does refinancing a car loan make sense?
The Car Is Worth More Than You Owe
A fundamental aspect of refinancing, if you’re upside down in the loan (you owe more than the car is worth), is that you won’t be able to get enough to pay off your existing loan. A lender will be very reluctant to write a loan on a car for more than they could get if they have to repossess it. With that said, if you do find a lender willing to take the risk, the interest rate will be high.
Lowering the Interest Rate
Let’s say your situation at the time of your purchase required you to sign onto a car loan at 15 percent interest—but things have changed, and you can now qualify for a car loan at five percent.
Depending upon the amount of time you have left in the loan, taking out a refinancing car loan could save you a considerable amount of money if you allow the loan to run its entire course.
Buying Out a Lease
At the end of most lease terms, you have the option of returning the car and getting another one or buying the car and keeping it. When you decide to buy the car, you are, in effect, refinancing it. You’ll take out a loan to pay off the residual value.
This can be a smart move if the residual value is such that buying the car at the end of the term will result in a favorable overall cost. In other words, if the total of the lease payments, as well as the purchase price and the cost of financing the buy pushes the complete cost out of line with what the car is worth you might want to reconsider that strategy.
You Need to Lower Your Monthly Payment
If you find you’re in a tight financial situation and a lower car payment would help, refinancing your car loan for a longer term will get you a reduced monthly payment. However, this should only be considered in dire situations.
You’ll wind up paying more for the car when those additional interest payments are folded into the equation. And, because the car will be considered “used”, you’ll probably be looking at a higher interest rate than the one you currently have.
You Don’t Have a Prepayment Penalty
While illegal in most states, some do allow lenders to charge you a fee for paying off the loan early. This is how they ensure a profit on the loan. If your existing loan has a prepayment penalty and you’re considering refinancing it, you’ll have to factor the amount of the penalty into your potential savings to determine whether or not refinancing is a smart move.
Long story short, there are situations in which refinancing a car loan does make sense. However, you do have to consider the circumstances very carefully, or you could wind up paying a lot more for less benefit than you expected.
