Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

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 decision?
Derek DeSoto

Dear Derek,
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 rate.

-- Updated: April 28, 2004