||Ask Dr. Don
Refinancing a car
Dear Dr. Don,
I want to refinance my auto loan for five years. I am trying to
decide between a fixed and a variable interest rate. Given the market
as it is right now, what should my considerations be in making this
A lot depends on your car's age and value, along with the terms
of the existing auto loan. A car is a depreciating asset. If you
don't have enough equity in the car through the principal component
of the monthly payments you've made, plus any down payment, then
you're upside down in the auto loan. It may be difficult to get
a new auto loan to pay off the existing loan when the car isn't
valued over or at the loan balance.
Make sure there's no prepayment penalty on the old
loan. If your current loan allocates monthly interest expense based
on the "Rule of 78" vs. simple interest then there is
a built-in prepayment penalty. Most lenders have stopped using this
rule, but you should still review your loan docs to confirm that
there's no prepayment penalty and that it's not a "Rule of
78" financing. This Bankrate feature
can show you how to land a good refinancing deal.
A variable-rate loan forces you to accept interest-rate
risk but should have a lower current interest rate than a five-year
fixed-rate loan. Variable-rate auto loans aren't widely available,
but are likely to be based on the prime lending rate, which currently
stands at 4 percent.
You can follow the prime rate and other key
lending rates on Bankrate. The prime rate follows changes in
the Federal Reserve's targeted Fed Funds Rate and Discount Rate.
There's some talk of an increase in Fed Funds, possibly this summer.
After 13 reductions in this interest rate cycle, it's likely that
the trend over the next five years will be for higher Fed Funds
Rates and therefore higher prime lending rates.
Choosing between a variable-rate loan and a
fixed-rate loan depends on the initial difference between the two
loan rates, how the variable rate loan's interest rate changes over
time, whether there's a cap on how high the variable rate can go
or a collar on how low the rate can go, and where you think interest
rates are headed. In the current interest-rate environment, if the
variable rate isn't at least a full percentage point less than the
fixed-rate loan, I'd take the fixed.
Don't forget to consider any closing costs and
title-transfer costs when evaluating the auto refinancing.
You can use Bankrate's "Should
you refinance your mortgage?" calculator to help you see
if it makes economic sense to refinance your auto loan at the new
-- Updated: April 28, 2004