What Is Refinancing A Car And How Does It Work?

AscentXmedia/ Getty Images; Illustration by Austin Courregé/Bankrate

If you’ve owned your car for a year or more, lenders may advertise better interest rates than you’re currently being charged. These lower interest rates can save you money on your monthly payments, making the process well worth it if you qualify. To get a lower rate, consider auto refinancing, which is getting a new loan for your car.

Refinancing could be a good option if you have good credit — especially if your credit has improved since you first took out the loan. If you have a poor interest rate due to dealer financing, you may find better rates even without excellent credit.

How does refinancing a car work?

Refinancing a car means taking out a new auto loan to pay off an existing car loan. The new loan will likely come with a different interest rate and term. You will then pay the new lender in fixed monthly installments, just as you did with the old lender.

Before refinancing, however, you need to be familiar with how refinancing a car works and how the process can affect your existing loan, as well as your credit. Refinancing could reduce your interest rate, lower your monthly payments and enable you to pay off the debt more quickly. However, this depends on your credit status and the rate you qualify for. Be sure to compare the pros and cons before refinancing.

When is it a good idea to refinance your auto loan?

It is important to know when to refinance your car loan. Refinancing your auto loan may be a good idea if any of the following apply to you:

• Your monthly payment is too expensive.
• Your credit score has improved since you received your loan.
• You financed through a dealership and now see other lenders offering better rates.
• Your vehicle has positive equity.

When is it a bad idea to refinance your auto loan?

Some circumstances could prevent you from refinancing or make it a less-than-ideal situation. You may want to hold off if:

• Your car’s mileage exceeds 100,000, the vehicle is over 10 years of age or you fail to meet other refinancing requirements.
• You’ll incur prepayment penalties for paying your loan off ahead of schedule that exceed potential savings.
• You’re upside-down on your loan.
• You’re almost done paying off the loan, and refinancing means you’ll pay more in interest.
• You’ve already refinanced your car loan recently.
• Your credit score is too low to qualify.
• You’ll get a higher rate if you refinance due to rising market rates or other factors.

How to refinance your car loan

Understanding the process of auto loan refinancing is just as important as knowing the benefits. Here are four steps to follow when refinancing a car loan.

1. Check your credit score: The auto loan rate you receive will depend upon your score. A good credit score over 670 is ideal.
2. Compare rates: Prequalify with several lenders to save your credit from taking multiple hits.
3. Apply online: You can do so over the phone or in person. Review the terms before signing.
4. Pay off your current loan:  Continue paying your existing loan until you verify it’s completely paid off. Any excess payments will be refunded.

Additional considerations before refinancing your car loan

There are a few additional considerations before refinancing your car, your credit score being one of the biggest. When you refinance, you may see a temporary drop in your credit score. However, after a few months of timely payments you will see your credit score rise again.

Keep an eye out for fees and charges. Your lender may charge extra fees, such as a transaction fee, registration fee, title transfer fee and early termination fee. Before you commit to a loan, ask for a copy of the fee schedule so you are aware of any additional charges that may be added to your loan.

To help better manage your expenses, consider the length of your loan. Most auto loan terms range from 36 to 94 months. While a longer loan term may be ideal for smaller monthly payments, it also means you will be making payments — and paying interest — for much longer. Instead, try to opt for a shorter term when refinancing a car.

Bottom line

Refinancing your auto loan may help you save money over the life of the loan. However, knowing when to refinance is crucial. This option is worth considering if available car refinance rates are lower or your credit has improved.

But if lowering your monthly payments would require extending your loan term, you may want to look into refinancing alternatives. On the other hand, if you’re ready for a new vehicle, trading in your car is another option.