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Auto loan refinancing can be a nonstarter

Greg McBrideWith auto loan rates at record lows, auto refinancing is a hot topic. Many have already refinanced a mortgage one, two or three times, and with an auto loan comprising one of the larger household debt obligations, refinancing is a logical consideration.

However, you can fill the trunk of a subcompact with instances where refinancing an auto loan may not be beneficial.

Refinancing an auto loan often means trading a new-car loan rate for a less-favorable used-car loan rate.

Rates on used-car loans tend to be 1 percent higher than those of new-car loans, as evidenced by Bankrate.com's latest averages of 8.56 percent and 7.52 percent, respectively. This difference may offset some of the benefit of lower interest rates from the borrower's perspective.

Borrowers, particularly those with good credit who took out a loan on attractive terms a year ago are unlikely to improve on those terms significantly. Successfully refinancing an auto loan entails both reducing the interest rate substantially and not stretching the term of the loan beyond the current repayment schedule.

Failing to accomplish both steps saps the appeal of an auto refinancing. For example, on a four-year, $22,000 auto loan, a difference of 1 percent in the interest rate reduces the monthly payment just 10 bucks. Not to say that such a refinancing wouldn't be worthwhile, but it doesn't generate the tangible monthly savings that attracts people to refinancing.

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If tangible monthly savings are what you want, be wary of attempts by the lender or your own temptation to stretch the term of the loan. In the same example above, refinancing a four-year loan into a five-year term and reducing the interest rate by 1 percentage point, can save $100 a month. But by extending the number of months you must make the albeit lower payment, any savings is either nonexistent or more than given back over the term of the loan.

What other factors can throw cold water on the idea of refinancing an auto loan? If you have encountered damage to your credit or the car since the loan's inception, this may negatively affect the interest rate you get on any subsequent refinancing attempt. Deterioration in creditworthiness, as measured by the lender, may prevent the borrower from qualifying for the best interest rate and instead qualifying for a higher rate may negate any benefit of refinancing. Damage to the vehicle may reduce the collateral value to the lender in the event of default. It may also increase the chances of future default in the lender's eyes. In either case, the lender is certain to command a higher rate to compensate for the perceived risks.

A borrower may be too far into the existing loan term to successfully refinance, but there are several options instead. The loan can be consolidated on a lower rate loan product, such as a home equity product, that can still be paid off on the original auto loan schedule. Any costs of originating such a loan must be modest, as the interest charges themselves grow more modest in the latter stages of a loan. Keep in mind, the idea behind refinancing is to reduce interest costs. In the final year of a 4-year, $22,000 loan at 8 percent, the borrower would pay just $315 in interest. If the borrower is not incurring much in the way of interest charges to begin with, little incentive to refinance exists.

Short of refinancing or consolidating onto another loan product, if the interest rate on the loan is enough to keep the borrower awake at night, making extra payments to prepay the loan is a sure-fire way to reduce interest costs.

Finally, two warning signals exist for borrowers before signing on the dotted line. Even when all else looks good, it is wise to avoid loans with prepayment penalties or where the interest is not computed on a simple interest basis. The idea is to preserve the flexibility to dispose of debts on an accelerated schedule as the borrower sees fit, and only to pay interest for the time the money is borrowed.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Personal Finance Advice channel on Bankrate.com.

-- Posted: May 16, 2003
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