Auto Refinance: When it Might be a Bad Idea

Getting an auto refinance loan is always a good idea, right? Not necessarily. While it may help people who can reduce their interest rate or the overall cost of financing their vehicles, refinancing a car loan isn't always a great idea. Here are five situations in which borrowers may want to think twice before making changes to the auto loan they have.

New Car, Upside Down Loan

New cars can lose up to 47 percent of their value in the first three years, according to Consumer Reports. If a car is less than three years old, refinancing it may cause the borrower to owe more than the car is worth, a situation known as an upside down loan or being underwater. In some upside down loan cases, borrowers may have to cover the shortfall between what is owed and what the car is worth -- a refinance auto loan dilemma.

Rates Are Higher

A new auto refinance that results in a higher rate than the consumer was paying previously is probably a bad idea -- but people do it sometimes if it lowers their payment, and they're not paying attention. This can happen when borrowers apply for a refinance at a time when their credit score and record isn't as strong as it was when they applied for the original loan. This also may happen if interest rates across-the-board have risen, even for those whose credit has not suffered.

Old Car, Longer Loan

Those who own an older car may want to remove "auto loan refinance" from their To Do lists. When a car loan is refinanced, the repayment starts over. Someone who refinances a three-year-old loan with a new five-year loan ends up with what is effectively an eight year car loan. By stretching out the repayment over a longer term, borrowers can end up paying more over the life of the loan, even if the rate and payment is lower. And what if the loan outlives the vehicle? Who wants to make payments on a car that's no longer roadworthy? Of course, this can be solved by refinancing to a loan with a shorter term. Loans with shorter terms have lower interest rates as well.

Ignorance

Responding to an unsolicited offer of financing without comparison shopping is not a good idea, as is taking on a car loan without reading the paperwork and making sure the terms are as good as advertised. Car owners should consider refinancing only when they can do it right, and actually improve their finances with new money.

Prepayment Penalty

Refinancing a car when the original loan has a prepayment penalty means the borrower has to pay extra to get out of the car loan, which can offset or even entirely negate the potential savings from a refinance. Other auto lenders find back-door ways to accomplish the same thing by structuring the loan so that in the beginning, monthly payments don't reduce the principal as much as they ordinarily would. This is called the "rule of 78" or "pre-computed financing" and it's illegal in many states. Consumers should pull out their original loan documents and read the fine print to make sure the cost of refinancing won't outstrip the benefits. And they should avoid loans with these traps in the future.

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