How To Refinance Your Car Loan

by Zina Kumok

Forbes Advisor

Wednesday July 14, 2021

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Stock image  (Source:Getty Images)

Refinancing debt is a common strategy to address issues with your budget. By swapping out your old loan for a new one with lower payments or a lower interest rate, you have the option to free up funds in the short term or save money in the long term.

If you have a car loan, that's a good place to start because they tend to require less upfront costs and fewer years than having to refinance a mortgage, for example. We'll break down everything you need to know about refinancing a car loan, including how to decide whether or not it's the right choice.

Why Refinance Your Car Loan?

Most borrowers choose to refinance their car loan in order to pay less interest on a monthly basis. When you refinance an auto loan to a lower interest rate, you can save hundreds or even thousands in total interest over the life of the loan.

You may end up with a lower monthly payment, which will free up money you can use to pay off other loans. A lower payment will also reduce your debt-to-income (DTI) ratio, which reflects your monthly debt payments divided by your monthly gross income. If you're planning to apply for a mortgage at some point, a low DTI could also help you qualify for a better interest rate.

Conversely, some borrowers choose to refinance their car loan to a shorter term so they can repay the loan faster. You can also refinance a car loan to a longer term, which can provide some wiggle room in your budget. Another reason to refinance could be if you first got the car loan with a co-signer and want to remove them from the loan.

Is a Refi the Right Choice for Me?

If you have a high interest rate on your car loan, and current market rates have dropped, you may want to consider refinancing. Interest rates are at near-historic lows right now, and you may qualify for a better rate.

Borrowers whose credit has improved significantly since they first took out the loan may also be eligible for a better rate. For example, if you had a bankruptcy or default fall off your credit report, your credit score may be much higher now.

If you can refinance with a co-signer or co-borrower, then you may receive better rates if you were the only borrower on the original loan.

When You Shouldn't Refinance Your Car Loan

If you're in the middle of shopping for a personal loan, mortgage or other financing option, now is not the right time to refinance your auto loan. Applying for a loan would hurt your credit score and possibly cause you to receive a higher interest rate on any loan offers.

If your current auto loan has a prepayment penalty, then refinancing could incur that penalty. Depending on the penalty and your current interest rate, it may not be worth refinancing. If you're not sure whether your loan has a prepayment penalty, look up the loan contract or call the lender and ask them. Some prepayment penalties only apply if you recently took out the loan, so it's best to verify over the phone or through documentation.

Does My Car Loan Qualify for a Refinance?

Auto lenders have rules on which cars are eligible for an auto loan refinance. Most lenders won't refinance a loan for a car with more than 100,000 miles or with a salvage title.

The lender will also assess the car's value before approving a refinance request. If the value is too low, you won't qualify. The lender will calculate the car's loan-to-value (LTV) ratio, which generally needs to be below 125% to qualify.

Before you apply to refinance your car loan, determine the LTV ratio. To find the car's current value, use sites like Kelley Blue Book, Edmunds and NADAguides. Take the average from all three sites to find a general estimate.

Calculating the LTV is simple. Divide the current loan balance by the car's value: the resulting percentage is the LTV. For example, let's say you have a $9,000 balance on a car worth $11,000. In this case, your LTV ratio would be 82%.

But if the current balance is $15,000 and the car is only worth $10,000, your LTV would be 150%. This is much higher than what most lenders allow, so refinancing is likely impossible.

How to Refinance Your Car Loan

Here are the basic steps you'll take to refinance your auto loan:

1. Get Your Documents Together

To apply for a car loan refinance, you'll have to submit information about your current car loan and the vehicle. You'll also have to provide your legal name, address, Social Security number (SSN), proof of employment and proof of insurance.

2. Shop for a Refi Lender

You should apply for an auto loan refinance with several different banks and lenders, including your current bank, online lenders and other local and national banks and credit unions. You can often leverage one bank's offer with another bank to get a better rate.

When you apply for an auto loan refinance, it will show up immediately on your credit report and count as a hard inquiry. A hard inquiry can cause a five-point drop in your credit score, so every auto loan refinance request has consequences to your credit.

However, if you submit all the applications within 14 to 45 days of each other, those multiple applications will only count as one inquiry. If you wait too long, you may miss the shopping window. In that case, each application will be treated as separate hard inquiries, and will have a greater negative impact on your credit score.

3. Application Process

Be aware that the lender will conduct their own appraisal of the car. They'll also run a credit check, verify your income and ask for proof of car insurance. You may need to provide a recent pay stub or tax return for you and any co-borrowers.

The auto loan refinance process is generally faster than a mortgage refinance, usually taking about two weeks from start to finish.

4. After You've Been Approved

Once you're approved with several different lenders, compare the various offers carefully. The most important factor is the annual percentage rate (APR) and total interest paid over the life of the loan. The APR includes the interest rates and any fees, including the lender and title fees. A lower APR means you'll pay less in fees and interest.

You may be approved for several different interest rates and loan terms. Loans with longer repayment terms generally have higher interest rates and lower monthly payments. A loan with a shorter term means you'll have higher monthly payments and a lower interest rate.

Look at your budget and decide how much you can comfortably afford each month. Remember, you can also make extra payments on the loan if you choose a lender that doesn't charge a prepayment penalty.

After you select the lender, you'll have to finalize the car loan. The new lender is responsible for paying off the loan balance from the old lender, but it's a good idea to double-check that this goes through correctly. It's also important not to fall behind on your car payments during this transfer process. Once the first lender is paid off by the new lender, they should return any extra payments you made during that window.

Once the loan is paid off, you can start making payments to your new lender. Consider setting up automatic payments so you don't have to worry about remembering your new due date.