Refinance your auto loan

Love your car but not the hefty interest rate you’re paying? Refinancing may be the way to go.

If you’ve built up job stability, made loan payments on time for a year or more or have otherwise improved your credit rating, you may qualify for a lower interest rate. However, if you have encountered damage to your credit or the car since the loan’s inception, this may not be the time to refinance — it might actually negatively affect the interest rate you get on any subsequent refinancing attempt.

Borrowers in good standing with the lender may be able to get a rate modification in which the lender agrees to simply lower your interest rate. Check this option first. If the lender is willing to reduce the rate, you’ll capture any interest savings without a refinancing. You’ll potentially save time and money.

If your current lender is unwilling to reduce your interest rate, start on the path to refinancing your loan.

The first step is to review your current loan documents.

  • Find out how high or low your credit score is by ordering your credit report. Every consumer is entitled to one free credit report each year. Or, you can order your reports. Here’s how.
  • Find out if your current loan charges prepayment penalties. Some loans smack borrowers who pay off a loan early with fees ranging from $25 to $200.
  • Find out how the rate on your current loan is calculated. Is it calculated with simple interest? With a simple interest loan, you’re charged interest each day based on the balance you owe. You’re looking to make sure that there aren’t any prepayment penalties, and that you don’t have a loan where interest is calculated based on “The Rule of 78s.”
What is The Rule of 78s?
With a loan using this rule, the lender typically collects three-fourths of a loan’s interest in the first half of the loan term. The earlier you try to pay off one of these loans, the more you’ll have to pay. The higher the interest rate, the more that payoff amount is going to hurt. Check the front of a loan contract to see whether it allows a refund or rebate of interest. That’s a sure sign you’ve signed on for a pre-computed loan. The good news is that most auto loans today don’t use this rule.

Changing rates

Refinancing makes the most sense and yields the biggest savings when a simple interest loan with no prepayment penalties is refinanced into a simple interest loan with a lower rate. So, start shopping for a better rate. This Bankrate search engine can help you find the best rates in your area.

Be sure to check out the deals available from local small banks and credit unions. Many small banks and credit unions send refinancing solicitations to recent car buyers. These offers may turn up in your mailbox just a few weeks after you’ve purchased a car. So be on the lookout.

Loan and title fees can eat into your expected savings. Ask the lender for a breakdown of these charges when shopping for your loan. You can also use Bankrate’s auto loan calculator to compare the new payment with your current payment.

If you owe more than the car is worth

If you owe more on your car than the car is actually worth, you are in a tight spot. Any lender willing to loan you enough money to pay off the existing loan will have a loan that is only partially secured, since your loan balance is higher than the car’s market value. That means that getting a lower interest rate isn’t likely.

If you are having trouble making your payments, the best alternative is to talk to your current lender about extending the term of your existing loan. They won’t want to do it, but if you can show them why this is important to keep you solvent, they should grasp that it’s better to restructure the loan than have you default.

Dangers to refinancing your car loan

There are pitfalls to avoid when considering an auto refinance. Here’s what to watch out for:

  • Are you currently in the market for a mortgage loan or other secured credit? If so, postpone the auto refinance. A loan application and approval will show up on your credit history and will have a negative short-term effect on your credit score.
  • Refinancing an auto loan often means trading a new-car loan rate for a less-favorable used-car loan rate. This difference may offset some of the benefit of lower interest rates from the borrower’s perspective.
  • Avoid loans with prepayment penalties or where the interest is not computed on a simple interest basis. You want to have the ability to pay off your loan faster if you are able later down the road. Make sure this is possible — that you only pay interest for the time the money is borrowed.
  • Be wary of attempts by the lender or your own temptation to stretch the term of the loan. Make sure you aren’t trading a lower monthly rate for a larger total loan.
  • Before agreeing to a refinance, do the math and make certain you are actually saving money.

Don Taylor, Lucy Lazarony and Amy Fleitas contributed to this story.