Refinancing your loans is often a one-way ticket to easy money. You can save on interest, decrease the life of your loan and be debt-free faster. What could go wrong?
But like other financial decisions, refinancing is more complicated than many consumers realize. It can involve a mountain of paperwork that can be difficult to decipher, and when everything blows over, you may not save as much as you had hoped.
If you have a car loan with a high interest rate and want to take advantage of current low rates, be sure to do the math before you refinance.
When You Extend Payments
One of the most common misconceptions is that refinancing your car loan is always a good idea – but that can vary. Most people refinance their auto loans to get a lower interest rate to save hundreds or thousands of dollars on interest.
Some lenders that offer you lower rates may extend your payment terms and inadvertently increase how much you pay in interest overall. For example, if you currently owe $15,000 on an original loan of $20,000 and are paying 3.99% interest, switching to an interest rate of 1.99% may seem like a no-brainer.
If you choose a seven-year loan, you could end up paying off your car for almost four years more than if you hadn't refinanced. That's four year's worth of payments you could use for retirement, an emergency fund or your child's college education.
Refinancing also comes with a set of fees that eat into any savings you hope to gain. Plus, some loans come with a prepayment penalty. If you refinance, you'll have to pay that penalty out of pocket.
When You Switch to a Variable Interest Rate
There are two types of interest rates you can get with auto loans – fixed or variable rates. Fixed rates stay the same throughout the course of your loan, while variable rates change based on the market's fluctuations. Variable rates have a range and often have a lower starting figure than a fixed-rate loan, making them more attractive to some buyers.
For example, a fixed-rate loan may have an 5% interest rate, while a variable-rate loan might have an interest rate range of 3.5% to 8%. If interest rates increase, you could start paying more in interest on your loan.
If you refinance to a variable interest rate, you may end up paying more in interest than if you had stuck with your fixed-rate loan.
When You're Applying for a Mortgage
Refinancing is often touted as a great way to save money, but like any other strategy, it only works if you understand the math behind it. Not every refinance is a good idea. It can cost you a lot of time, extra money and will show up on your credit report. A refinance will often cause a hard inquiry to appear on your credit report and may decrease your credit score.
If you're applying for a mortgage or refinancing your mortgage, an auto loan refinance may make you ineligible for the low rates you hoped for. Since mortgages are usually bigger than auto loans, you could lose thousands of dollars in potential savings by choosing to refinance your auto loan.
If your credit score has recently improved and you want to capitalize by refinancing both your car loan and mortgage, do the math to see where you'll save the most amount of money. You'll likely be better off refinancing your mortgage first, but it will also depend on how high your auto loan interest rate is.