How Can Auto Loan Refinancing Affect Your Finances?
When you refinance a car, you replace your current car loan with a new one of different terms. In practice, auto refinancing is the process of paying off your current car loan with a new one, usually from a new lender. This process can have varying outcomes for car owners.
Most people refinance to save money. But this goal can take multiple forms. Some wish to lower their monthly payments. Others want to reduce their interest rates or adjust their loan term lengths. Still, others have more personal reasons to refinance, such as removing co-signers from their loans. No matter what is motivating you to consider refinancing your car, it is important that you understand the possible outcomes of refinancing a car.
Possible Car Refinance Outcomes
Not all car loan refinance deals are the same, but customers who chose to refinance often seek one of the following outcomes (this list is not exhaustive).
Lower Your Monthly Payments
Most of the time, people seek car loan refinancing to lower their monthly payments. This priority is understandable because monthly car loan payments can have an immediate impact on a household’s monthly finances. However, your monthly payment should not be your only consideration when refinancing as the sections below describe.
You have two ways to lower your car loan monthly payments. You can get a lower interest rate, you can extend your loan term, or you can do both. Usually, the best way to lower your car loan payments dramatically is to extend the number of months over which you pay for your car. However, when you extend your loan term, you may end up paying more for your car in total than you would without extending it. Still, if your lender allows you to extend your loan term and gives you a lower interest rate, you may both lower your monthly payments and pay less in total for your car. The example below will illustrate how this outcome can occur.
Decrease Your Interest Rate and/or Reduce Your Interest Charges
While it is interrelated with the goal of lowering monthly payments, some refinance customers prioritize lowering the interest rates on their loans. If during the course of your car loan, you improve your credit worthiness in the eyes of lenders (they sometimes evaluate you according to the Four C’s of Credit), then you usually can get a new loan on your car with a lower interest rate, and when you lower your interest rate you may reduce the total interest charges you pay on your car loan – assuming your car loan term is not extended or not extended by too many months.
Change the Length of Your Loan
Sometimes refinance customers seek refinancing with an aim to change their loan term lengths. However, this goal usually has more to do with lowering monthly payments than just changing how many months over which a customer pays for his/her car.
Remove or Add Someone as a Co-Signer to Your Loan
For various personal reasons, sometimes car loan borrowers want to refinance to remove someone from or add someone to their car loans. Refinancing is an easy way to take someone off of your car loan because the refinance process gives you a new loan with a new contract.
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Example: Refinancing a Car Loan
Pretend that one year ago you purchased a car for $20,000. A lender loaned you this amount at 6% interest (APR) to be paid back over 48 months. Now, 12 months later, you decide to look for refinancing, because you would like to reduce your monthly payments. So, using an auto loan service, you connect with a new lender that will pay off your old lender and give you a new loan. This lender offers to give you this loan at a 3% interest rate (APR) with a loan term of 48 months. Effectively, by refinancing with this loan term, you will be paying for this car for 60 months, because you already made 12 monthly payments and you are signing up to pay for your new loan for another 48 months.
So, what would the financial impact of a car refinancing have on how much you pay for your car? For sake of simplicity in this example, let’s assume that you will not pay any fees to refinance and are not going to buy any service protection products with your new loan (note, refinancing almost always comes with fees and many refinancing customers opt to buy service protection products). After making your 12th payment on your old loan, you still owe your lender $15,440. Your new lender loans you this amount by paying your old lender the $15,440 you still owe. Your first payment on your new loan occurs in what would have been the month of your 13th car payment on your old loan.
The monthly payments on your new loan would be $341.75 compared to the $469.70 per month you paid on the original loan, and, by the end of your loan, you would pay $22,040 with refinancing after the first 12 months [$22,040 = $469.70 *12 + $341.75 * 48]. Without refinancing after 12 months, you would pay $505 more for your loan, ultimately costing you $22,546 for your loan [$22,545 = $469.70 * 48]. If you would like to know more about how any of the numbers in this article are calculated, read this article on how car loan interest works.
The graph below depicts how you would pay down your car loan(s) in this example with and without refinancing.
Notice how the car loan balance with refinancing line (in orange) falls at a slower pace over the loan term than the car loan line without refinancing (in blue). Because, in this example you extended your loan term, you pay less of your principal each month and have more time to accumulate interest charges. As a result, you pay off your loan at a slower pace than before refinancing. However, your new interest rate of 3% is sufficiently below your old interest rate than in the end you cumulatively pay less interest charges than if you had not refinanced.
Please note, you should always make your car loan payments as scheduled even if you are in the middle of the refinancing process. Moreover, just because in this example you make your last payment on your old loan in month 12 and make your first payment on your new loan the next month does not mean that the car loan refinancing process can always be completed in the time span between car loan payments.
While the example above illustrates how refinancing can benefit a borrower, you should note that refinancing can have various impacts on a person’s finances. When and if you choose to refinance, you may or may not change the length of your loan, and your interest rate does not necessarily have to change – although most of the time it will. Ultimately, every car refinancing deal is different and every refinance customer has personal motivations for refinancing. For this reason, you may benefit greatly when you work with an auto loan company that takes the time to learn about your needs and will match you with a car loan that meets those needs.