Three reasons to refinance a car

One of the most common reasons people need to refinance their car loan is to lower their monthly payments.

When you refinance, your lender will issue you a new loan. This new loan may have a lower monthly payment if it offers a lower interest rate, extends your loan term, or a combination of both.

A lower interest rate is always a good thing because until your loan is repaid, you will have to pay your lender interest on the outstanding loan balance. So if you keep the term constant, a lower interest rate will mean you have to pay less for your loan in the long run.

It’s the length of your new loan term that requires a closer look.

If your new loan extends the number of months you pay for your car, your payments will be lower, assuming a) your interest rate isn’t higher than it was before you refinanced and b) you don’t finance too many additional costs into your new loan. Again, lower payments are a good thing. However, because of the way car loan interest rates work, the more months you pay for your car, the more interest you’ll pay in your payments. So if you extend your loan term, you may end up paying more cumulatively for your car over the life of your loan.

What could happen to your monthly payments if you refinance a car?

For example, let’s say you took out a $20,000 loan a year ago with an interest rate of 6% and a loan term of 48 months. Your monthly payments on this loan would be $469.70. After 12 months of payments, you decide to refinance your loan. If you simply lower your interest rate to, say, 3% but don’t extend the loan term, your new payments will be $449.01. The rates aren’t much lower, but you’ll end up paying less for your car.

Instead of lowering your interest rate, simply extend your loan term by 12 months. In this case, your new payments would be $362.61. These payments are more than $100 less than your previous loan payments. However, you will ultimately end up paying more for your car because you will have to pay more interest over the life of your loan.

None of these scenarios may sound all that advantageous. But let’s say you refinance your loan so that you lower your interest rate to 3% AND extend your loan term by 12 months. For this new loan, your new payments would be $341.75 (down from the original $469.70) and you would save over $500 in interest costs over the course of your loan!

While many refinance customers worry about their car loan payments, some focus on how much they will pay overall for their car.

As the example above shows, monthly payments don’t tell the whole story when you consider how much you pay for your car. If you pay a high interest rate over a long loan term, you may have low monthly payments, but at the end of your loan you’ll end up paying a lot of money for your car. For this reason, some refinancing customers are primarily looking to lower their interest rates.

A lower interest rate means lower interest charges per month, which in turn means a larger portion of your monthly payments goes toward paying off your car loan (i.e., how much you borrowed) and a smaller portion goes toward paying interest to your lender.