Yes, You Can Refinance a Car Loan. Should You?

Record low interest rates have given many homeowners refinancing fever, with mortgage refi up 51% in mid-February from a year ago, according to the Mortgage Bankers Association. That fever might be contagious, causing you to wonder about refinancing your car loan for similar reasons: getting a lower rate that offers a quicker payback or a lower monthly payment. 

Related: How to Calculate a Car Payment

Could you refinance? Quite likely. Unlike with some mortgages, it’s rare that your current loan will have a prepayment penalty or a fee for paying it off early. Also, unlike mortgages, it’s rare for an auto refinance to have significant upfront costs for the new loan. 

Refinancing is “pretty quick and pretty easy to do,” said Phil Reed, an automotive columnist at financial advice site NerdWallet. He added that typically, not a lot of documentation is required: There’s “no reason not to if you think you can get a better rate.”

But that’s the question. 

“For a successful refi of an auto loan, you have to meaningfully lower the rate and not extend your loan term,” said Greg McBride, senior vice president and chief financial analyst for personal finance site Bankrate.

It might be tough to find a significantly lower refi rate for a couple of reasons. First, auto loan rates have been low for a while, so most people already have a pretty good rate for their situation. Second, when you refinance a new-car loan, you’re now borrowing on a used car. While the gap on interest rates has narrowed in recent years, used-car loans still have higher rates than new-car loans. 

“You have to move the rate a lot more to generate meaningful savings,” McBride said. On an initial loan of $25,000, he added, “8% to 7% saves less than 10 bucks a month, [while] 8% to 4%, now you’re saving $28 a month.”

And it’s tempting to save more per month by extending the loan term, to add a year or two to your payback. Bad idea, say the experts: Even at a lower rate, paying interest for more months could mean you’ll actually spend more to pay off your car in the long run. The smart financial choice is to keep your payment level and pay the car off faster. 

“If you’re getting a better rate, you should shorten the loan, but that’s a hard thing to tell people,” Reed said.

These Are the Best Refi Candidates

All that said, some people definitely should be looking at a refinance. The prime candidates are people who have significantly improved their credit score — their creditworthiness as rated by the major credit reporting companies (Equifax, Experian and TransUnion) — since taking on a relatively high rate for their current auto loan.

“If you’ve improved your credit, if you were in a corner before and you ended up paying an above-market rate, that’s the classic example” of a good refi candidate, McBride said.

You can check your current score with the big credit companies through one site. Federal law entitles you to one free report each year. However, during the COVID-19 pandemic and through April 2021, the companies are offering free weekly reports at the same site. If you need to improve your credit score, plenty of advice exists on how to do that, including this piece at Bankrate. 

A second group due for a refi would be consumers who arranged financing through a dealer and ended up paying more for the loan than they should have. This can happen when the dealer arranging the loan gets a rate quote for the buyer from a lender and then marks up the loan to a higher rate for the service. Many lenders allow this hidden markup, an extra profit for the dealer at the expense of the buyer.

“Perhaps they were taken advantage of in a dealership,” said Reed, who noted that shoppers with mid-tier credit are most vulnerable to this. Federal settlements also indicate the possibility of higher risk for minority buyers. Reed says it’s easy to happen to car buyers. 

“Your head is spinning when you’re in the [dealership’s] finance office,” he said. “And a lot [of] people are very, very vulnerable talking about credit.”

The danger is one reason the experts and the Consumer Finance Protection Bureau all recommend shopping around for loans ahead of time and getting preapproved for financing before you go to a dealership.

Not-So-Good Candidates for a Refi

If you took a long new-car loan and you’re currently underwater — meaning you owe more than the current value of the vehicle — a refi is not likely the answer. Even if you find a willing lender, your collateral for the loan (i.e., your vehicle) is worth less than the amount you want to borrow. 

“If you find someone, you’re not gonna get a great rate,” McBride said.

A refi is also a risky option if you are struggling to make your payments. 

“Getting a lower payment is a possible strategy if your only option is missing loan payments,” Reed said, but it’s a risk. “You can lose your car and damage your credit and end up with no options. That’s a downward spiral.” 

Before trying to refinance, McBride advises contacting your current lender for help. “Payment forbearance is extremely common,” he said. “Go to your existing lender for payment relief if you’re experiencing financial distress. Working with your lender won’t work against your credit.”

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How to Decide — and What to Watch Out For

• Shop around: Contact at least three lenders for rate quotes, starting with your current lender. Most lenders will do what’s called a “soft credit check” to evaluate you as a potential borrower and estimate your loan rate. Your rate will not be final, however, until you formally apply, have a full credit check (known as a “hard” check) and get a new loan offer to sign. 

“Be prepared for the end result to be higher than [the] original quote after a credit check,” Reed said. But the lender “should explain” the reasoning, which could include a credit issue or even a change in the value of the vehicle.

• Guard your social security number: Getting an initial estimate should not require a lot of your information.

“Be wary of any company that is taking a social security number, both for security and also because it lets them [check] your credit out of your control,” Reed said. “Be clear on whether or not they are doing a ‘hard’ credit check, which requires an SSN” and can affect your credit rating.

• Calculate the benefit: Cars.com offers a loan calculator you can use to compare your current interest rate and months remaining on the loan with any new rate quote. You can see what you might save per month. You should also calculate and compare the total interest you’d pay over the life of the loan, which might convince you to keep the same payment and shorten the loan. Along with banks, credit unions and other lender sites, the finance sites also list potential refi lenders.
  
• Shop around, but move quickly: Multiple loan applications over an extended period can be a red flag for credit agencies. Each actual application will trigger a full credit check. 

“Don’t drag your feet doing several lenders over a few months,” McBride said. He added that you will not be penalized for shopping around, however, if the multiple applications are all within a “compact time frame” of 30 to 45 days. “All those are counted as one application.”

• Read the loan offer and check it twice: Don’t sign until you know the details. 

“You need to make sure that what you get in the mail matches what you arranged online,” Reed said. “You run the possibility of them inserting something in the loan document you are not aware of. You could be signing something that is not right. They could put a service contract or a warranty in it, or put fees in that they rename as something else, saying ‘everybody charges that.’”

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