Auto Refinance: Risks and Benefits

Refinancing can be a great way to save some money on your auto loan if you do it right.

You're looking for some extra cash, and you see the ad on TV: Refinance your car and save money, or just lower your monthly payment by extending the length of your loan. Question is, is it really a good idea? Before you refinance, it's important to understand that a positive tool like refinancing can be used in shortsighted and reckless ways.

Refinancing involves transferring your car's title — official ownership — from one creditor to another. The assumption when you sign up for a car loan is "that's it," said John Ulzheimer, president of consumer education at Credit.com, but as long as you're still paying for your car loan, you can refinance it.

"If your credit score improves, even by just 50 points, you should ... refinance the auto loan," Ulzheimer said.

Likewise, if interest rates were high when you purchased your car but have since come down, refinancing is a prudent option, said LendingTree.com spokeswoman Allison Vail.

"If you see a better auto interest rate than you currently have, you should refinance," she said; even if it would only reduce your annual interest payments by around 1 percent, refinancing is worth a look.

To find a better rate, though, you'll need to shop around. There are plenty of websites that can help: LendingTree.com, Eloan.com, Bankrate.com and Credit.com are all good places to shop for rates. Capital One Auto Finance is also one of the biggest online lenders, with attractive rates for qualified borrowers.

If you're approved for refinancing, the process itself is fairly simple. You get a check from your new lender, which you use to pay off the old loan. From there, you start paying your new lender monthly.

The potential advantages of refinancing are twofold: It can reduce your monthly payments and lower the overall cost of your car. For instance, say you're two years into paying off a $35,000 car that you originally financed using a six-year loan at 8.5 percent interest ($622 a month). The table below shows what you'll pay if you continue with that same loan, versus refinancing the final four years of the loan at 5.5 percent.

Another refinancing strategy — if you can afford it — is to secure a lower interest rate and its resulting lower monthly payments, but keep paying the same amount you were paying before. What that will do is effectively shorten your loan because your total financed cost would have been reduced when you refinanced at a lower interest rate. For instance, using the example above, if you continued to pay $622 a month after refinancing the loan, you would have your car paid off after about 45 months, rather than 48 months.

Of course, there are also borrowers who will seek to lower their monthly payments when refinancing. This can be done by lengthening the loan term for the vehicle and could be an acceptable compromise for someone who needs to cut their monthly payments in order to keep their car. It is not, however, for people looking to save money in the long run, because it increases the overall cost of the loan.

"If you are turning a four-year loan into a nine-year loan, that's not really a good idea," Ulzheimer said.

Also, creditors may limit refinancing options on aging vehicles because the collateral (your aging car) won't have enough resale value. In general, it's best to refinance toward the beginning of a car loan, not the end.

"Interest is front-end, or front-loaded," Ulzheimer said. "It's more advantageous to refinance at the beginning because that's when you're paying the most interest."

There may also be prepayment penalties in your original loan agreement that can make refinancing a costly option. Some lenders can make you pay a portion of the remaining interest when you refinance, not just what's left on your principal.

One such penalty is contained in what's called a "pre-computed loan." In a pre-computed loan, you're obligated to pay the principal plus the total interest, even in the event of an early payout. These loans are less common, but make sure to check if this is what you've signed up for. If you did, the benefit of refinancing to save on total financed cost is lost.

Typical fees for refinancing include a lien-holder fee, which LendingTree.com estimates at around $5-$10, and state re-registration fees, which can range from $5 to $75. These fees shouldn't significantly impact the monetary benefit of refinancing.

Other considerations include opting for a home equity line of credit over auto refinancing. A HELOC could give you a lower monthly payment than refinancing because it's a longer-term loan (usually 10-15 years), while vehicle refinancing is usually structured in two-year to four-year periods. Ulzheimer said home equity loans are a smart option if you're financially responsible because rates are good and the interest you pay is tax deductible.

With the drop in housing values and tightened credit, however, it's more difficult to secure a home-equity loan now than it has been in the past few years. Also, it's important to understand that refinancing your car through a home equity loan secures your auto loan with your home.

"If you stop making payments on your auto loan, you could lose your home," Vail said.