Auto loan refinancing can be a nonstarter
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
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
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.
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
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 advice regarding your specific
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