Although vehicles have gotten smarter and more efficient, their cost has steadily increased to the point that most auto loans extend for more than half a decade. For most folks, however, the cost of buying a vehicle is worth paying, especially when it’s the only reasonable option for getting to and from work.
But, worthwhile or not, that high price tag means you need to be smart about how — and how much — you pay for your vehicle. For example, auto loans are a common method of paying for a new vehicle, but a five-figure loan can get expensive, especially when it’s stretched out over the course of six years or more.
That’s why the interest rate you’re charged for your loan is so important, as it determines the overall cost of your loan. So, if you got a sour deal when you first took out your loan, you may be paying way more for your vehicle than you could be paying if you refinanced your loan. Of course, not every loan is ready or worth refinancing. Here are a few signs it might be time.
When You’ve Improved Your Credit
The very best time to refinance any loan, including an auto loan, is when you’ve seen big credit score improvements — at least a few dozen points. That’s because the interest rates you’re offered for any credit product will be heavily dependent upon your credit profile; the better your credit, the better the interest rates you’re offered.
For example, a credit score of 600 may qualify you for an auto loan with a 9% interest rate. If your credit score rose from a 600 to a 700, however, you’d likely be able to refinance closer to the 4.5% range. On a $20,000 loan over three years, that difference in interest rates could mean almost $1,500 in savings.
There are lots of ways to boost your credit scores, though the quickest is usually to pay down existing debts, particularly if you have any credit cards with high utilization rates. Even something so simple as ensuring you pay all of your debts on time for six months or so can have some large, positive impacts on your credit scores that may result in being offered better interest rates when you refinance.
When You Have More Than a Year Left on the Loan
Very few loans are free, even refinanced ones. In the majority of cases, you’ll wind up paying some sort of loan fee to refinance your vehicle loan, which means you’ll need to make sure you’ll make up any fees with interest savings. If you only have a few months left on your loan, the chances are low you’ll actually see enough savings from a lower rate to justify the loan cost.
The exceptions here are in the math; if you can get a fee-free loan, for instance, then it might be beneficial to refinance. It may also be a good idea to refinance your loan if you can significantly reduce your interest rate (i.e., by more than a couple of points), as the math may then work out in the favor of overall savings.
When You Can’t Afford Your Payments
In some cases, you may need to refinance even if you can’t get an appreciably better rate so that you can avoid falling behind on your loan. Basically, if you are unable to afford your monthly loan payments, you may be able to refinance your loan with a new loan that has a longer repayment term. By extending the amount of time you take to repay the loan, you can reduce the size of the monthly payments.
While this method can be helpful if you are short of options for staying ahead of your loan, it should be considered Plan B — or C, or even Plan D. That’s because every additional month you extend your repayment term will mean another month worth of interest fees, adding more and more to the overall cost of your vehicle.
As an example, consider a $20,000 car loan with a 7% APR. If that loan is repaid over four years, the monthly payment would be about $480, and the total interest paid for the loan would be just under $3,000. That same loan repaid over seven years would have a monthly payment of roughly $300 but a total interest cost of over $5,300 — more than a quarter of the amount borrowed.