If your budget is tight and you are struggling to keep up with your monthly obligations, finding a way to lower your auto loan payment might seem like a smart move. Usually, car payments are one of the largest expenses in a household for those with an auto loan. The average new vehicle loan payment comes in at $554, while the average for used cars sits at $391. If refinancing lets you lower that amount, going through with it may be enticing. But refinancing a car isn’t always the best way to go. In fact, it can get you into some financial trouble if you aren’t careful. If you are considering an auto loan refinance, here’s why refinancing is a bad idea.
You Might End Up Paying More
In most cases, a person refinances their auto loan to secure a lower monthly payment. One way to make that happen is to extend the repayment term. For example, you may have 36 months left on your existing loan. If you refinance into a 48-month loan with the same interest rate, your monthly payment shrinks.
However, by extending the term, you’ll pay more in interest unless you secure a substantially lower interest rate than your original one. If you owe $5,000 on your car and have a 6 percent interest rate, a 36-month term leaves you paying $476 in interest. Bump that up to 48 months, and you’ll spend $636 in interest instead.
That example relies on the idea that you’d get the exact same interest rate, as well. Often, that isn’t what occurs. Whether yours goes up or down depends on several factors. The state of your credit score and report are major considerations.
Similarly, whether your vehicle was considered “new” or “used” when you first bought it, and its current age now, both play a role. In most cases, older vehicles end up with higher interest rates in comparison to new ones.
Finally, if your current loan has a prepayment penalty, you’ll have to pay it when you refinance. That could mean having to shell out several hundred dollars just to close out the obligation.
You’re Going to Impact Your Credit Report
Refinancing your auto loans means essentially applying for a new one. When you initiate the process, the refinance lender is going to run your credit. As a result, you’ll end up with a new hard inquiry on your report.
Whether that hard inquiry has a significant impact is influenced by a few factors. How many recent inquiries are on your report is a big one, as too many could indicate you are in financial trouble. Your credit score will decline for a short period with any new inquiry. However, if the total number gets high enough, the score reduction could hang on for a while.
Then, if you go forward with the new loan, you’re impacting your credit again. The new loan will pay off the old one. While that will close out the original account, that isn’t all it does. The average age of your credit lines will also decline. Your refinanced loan’s date will essentially replace the original. That reduces the average age of your account.
If you aren’t intending to get additional credit in the next few years, this may not matter. However, if you might need a loan, mortgage, or credit card relatively soon, this damage to your score could make that harder to pull off.
You Could End Up Upside Down
While you are paying off an auto loan, it’s best to ensure that the value of the vehicle exceeds the remaining balance on the loan. That way, if you end up in real financial trouble, you could theoretically sell the car for enough to eliminate the loan. Similarly, if you end up in an accident and your vehicle is totaled, the insurance company might provide enough cash to handle the remaining balance.
When you refinance for a longer-term, your odds of ending up upside down go up substantially. You’ll be spreading out the payments over a longer period, so you aren’t working your way through the principle as quickly. With depreciation also being a factor, your car could end up worth less than what you owe on it.
Once you end up upside down, you could face a variety of financial issues. Selling the car to eliminate the loan isn’t an option, as you can’t get enough for it to cover the debt. In fact, you might not be able to sell it at all, as you can’t get a clear title that you could transfer to someone else.
Similarly, if you get in an accident and the car is totaled, what you get from the insurance company probably won’t cover what you owe. You’ll get stuck paying on a loan for a vehicle you don’t even have anymore.
That’s a major hardship, especially if you have to get another vehicle to replace the totaled one. You may not be able to afford a second monthly car payment or may not qualify for a new loan since the old one is still there.
Ultimately, refinancing a car loan typically doesn’t make sense. Unless you can get an interest rate that’s substantially lower than your existing one and you don’t change the repayment term, refinancing is a bad idea. It introduces more risk into your financial life, and you’ll usually end up paying more over the long run. As a result, it’s better to look for other ways to balance your monthly budget, ensuring you don’t accidentally make a touch situation worse.
Have you ever refinanced a car? Do you think it was a bad idea? Why or why not? Share your thoughts in the comments below.
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Tamila McDonald is a U.S. Army veteran with 20 years of service, including five years as a military financial advisor. After retiring from the Army, she spent eight years as an AFCPE-certified personal financial advisor for wounded warriors and their families. Now she writes about personal finance and benefits programs for numerous financial websites.