How to Refinance a Car Loan in 7 Steps
If you feel like your monthly car payments are too high, you might consider refinancing your car loan as a way to reduce the cost.
There’s a lot to consider before making this decision though, both in terms of deciding whether refinancing is the right move and in terms of getting the best deal.
To help you learn how to refinance a car loan, we’ve put together seven steps you can follow to make your refinance a success. Here’s what we’re going to cover:
- Collect Your Documents
- Determine If It Makes Sense to Refinance
- Comparison Shop for Rates
- Decide on a Lender and Apply
- Pay off Your Old Loan
- Begin Making New Monthly Payments
- Protect yourself
Lenders typically require certain documents in order to verify your identity, evaluate your creditworthiness, and process your loan application.
Here are some of the documents a lender might ask you to bring when you apply:
Proof of employment and income
Todd Nelson, Senior Vice President of Business Development at the online lender Lightstream, says that lenders typically look at two factors when it comes to income: the amount you earn and the source of the income.
If you’re an employee, you’ll typically need to provide pay stubs from the last month or two. If it’s the beginning of the year, a W-2 from the prior year might be sufficient
If you freelance and you receive 1099s from several different companies, Nelson says that lenders will generally want to see your tax returns instead.
To improve your chances of getting approved, Nelson recommends thinking about all of your income sources.
“If you have a side job or some other source of income, tell the lender about that too,” he says. “It may be beneficial to you as the lender evaluates your creditworthiness.”
Proof of residence
Lenders want to know where you live not only to be able to contact you, but also to know where the car is garaged in case you default on your loan.
Here are some documents you can use to prove your physical address:
- Drivers license
- Bank statement
- Mortgage, credit card, or other loan statements
- Utility bill
- Property tax bill
- Auto insurance policy
- Homeowners or renters insurance policy
Proof of insurance
Most states require a minimum amount of auto insurance, and lenders will require proof of coverage before they are willing to make a loan.
You can provide your Insurance ID card as proof, or you can ask your lender if other documentation is acceptable.
While you’re not required to bring a copy of your credit report to the bank when you apply, it’s a good idea to get a copy for yourself to make sure you know what’s in it.
If you catch any errors or spot any areas that could use some work, it may wise to make some improvements before you apply.
Since your vehicle serves as collateral for your auto loan, the lender will need to collect certain information about your vehicle in order to verify that it’s valuable enough to cover the loan in case you default.
Specifically, you’ll need to share the vehicle’s year, make, model, and vehicle identification number (VIN) so that the lender can estimate its value. Your vehicle’s registration card should provide all of these details.
Current auto loan details
You’ll need to provide the payoff amount from your current loan so that your new lender knows how much you need to borrow.
Keep in mind that some lenders may require documents that other lenders don’t. Once you’ve picked the lender you want to work with, call ahead and ask which documents you need to bring to your appointment with a loan officer.
The goal of refinancing is typically to get a lower interest rate, monthly payment, or both. If your credit score isn’t up to snuff, though, you may have a hard time accomplishing that goal.
To see where you stand, start by checking your credit score. You can use LendingTree’s Free Credit Score, which pulls your credit history from TransUnion using the VantageScore 3.0. You’ll also be able to see the different factors that impact your score so you can pinpoint where you can improve if needed.
VantageScore has the following credit score ranges:
- 781 to 850: Super prime
- 661 to 780: Prime
- 601 to 660: Near prime
- 500 to 600: Subprime
- 300 to 499: Deep subprime
The higher your credit score, the better your chances of getting approved for a low interest rate. If your credit score isn’t considered prime or super prime, you can take steps to improve your credit score before you apply.
Keep in mind, though, that your credit score isn’t the only thing lenders consider.
“For someone with a FICO score that meets our minimums,” says Nelson, “the score is far less relevant to the credit decision than looking at their usage of credit and the depth of their credit history.”
In other words, if you have an 800 credit score but only six months of credit history, a lender might still be wary about approving your application.
Shopping around is the best way to find the lowest interest rate available to you. Compare at least three to five lenders to see what kind of interest rates you qualify for.
Here are some of the factors you’ll want to consider as you compare your options.
Annual percentage rate (APR)
This number includes both the interest you’ll pay and any additional fees.
In some cases, a loan with a lower interest rate may be more expensive than a loan with a higher interest rate because of the other fees, and this will help you figure that out.
A short loan term could make your new loan more difficult to afford, even if it offers a lower interest rate, because it will require higher monthly payments.
On the other hand, a longer term will increase the overall cost of the loan, since you’ll be paying interest over a longer period of time.
For example, let’s say that you owe $15,000 on your current auto loan, it has four years remaining, and your monthly payment is $400. If you qualify for a 2.99% APR refinance but your new loan term is three years, your monthly payment will actually go up to $436.15.
If, however, you opt for a loan with a 3.5% APR and a four-year term, your monthly payment will drop to $335.34. However, you’ll pay $1,096.32 in interest over the life of the loan, compared to only $701.48 for the shorter-term loan.
You can use LendingTree’s auto loan payment calculator to do the math on your various loan options.
Penalties and fees
Nelson points out that while many people focus on interest rates when considering a refinance, and while that is certainly important, they should also be on the lookout for other fees that could add to the cost of the loan.
According to Nelson, common fees that lenders might charge include:
- Origination fee
- Funding fee
- Title fee
- Document fee
- Prepayment penalty
Pay close attention to the lender’s disclosures and other fine print to understand which fees you might be on the hook for.
Once you choose the lender with whom you want to work, you can start getting ready for the application. With your documents in hand, you can head to the nearest branch if you’re applying in person, or simply go to the lender’s website to apply online.
Filling out an application shouldn’t take too long if you’ve prepared and have all the documentation you need, though the length of time it takes to approve your application can vary depending on the lender you choose and the documents you submit. To speed up the process, Nelson recommends having all the information the lender might ask for readily available.
If you get approved, the lender will provide you with a loan amount, interest rate, and any applicable fees. At that point, you can decide whether to accept the loan.
Your new lender will pay off your old loan once you’re approved and accept the offer, though the specifics of how this is done can vary.
According to Nelson, some lenders, like Lightstream, will deposit your new loan amount into your checking account and allow you pay off your old loan yourself. Other lenders will pay off your old loan on your behalf.
Either way, your previous lender will then transfer the vehicle’s title to your new lender, who will keep it on hand until you pay off the loan in full.
If your old loan has a payment due soon, you may want to contact them to let them know that your entire loan will be paid off so that you can avoid being charged a late fee.
Once your new loan is approved, your new lender will also let you know when your first payment is due and other payment terms you need to know.
If you had automatic payments set up on your old loan, make sure to turn those off. Then set up autopay on your new loan, so you don’t accidentally miss any payments. If you have room in your budget, you can also consider making extra payments in order to pay off the loan early and save some money.
For example, let’s say these are your new loan terms:
- $15,000 balance
- 3.5% interest rate
- Four-year term
- $335.34 monthly payment
With these terms, you’ll pay $1,096.32 in interest over the course of the loan. If you add an extra $50 to your payment each month, you’ll only pay $945.35 over the life of the loan, for a savings of $150.97.
As you’re considering whether to refinance your car loan and looking at the different terms lenders have to offer, it’s important to watch out for some potential pitfalls along the way.
Be wary of extending the loan term
While opting for a longer term loan can certainly reduce your monthly payment, it can also significantly increase the total cost over the life of the loan.
In other words, a shorter term loan is usually a better deal, though there are situations in which extending the term may be warranted.
“If you’re in a situation where you have to lower your payment to make ends meet, then obviously refinancing and spreading that out over a longer term would help,” says Ryan Mohr, CFP®, a fee-only financial planner and the owner of Clarity Capital Management. “As long as you’re well aware that the total amount of money spent on that car will cost you more out of pocket given that the interest rate is spread out over a longer term.”
Even if you do take out a longer term loan, it’s worth noting that you can eventually start making extra payments on it if you’re able to find room in your budget, which could significantly reduce the overall cost.
“If at any point in the future you’re able to add money onto that payment, you could end up paying it off earlier,” says Reshell Smith, CFP®, the owner of AMES Financial Education & Consulting.
How to refinance when you owe more on the auto loan than the car is worth
If the balance on your current auto loan is greater than the value of your car, you may have trouble refinancing through a traditional lender.
According to Nelson, many traditional lenders cap their loan at the vehicle’s value because the car itself serves as collateral for the loan. If the car is worth less than the loan, the lender can’t be sure of recouping its money if you default.
But other lenders, and particularly online lenders like Lightstream, may be more willing to refinance in this situation because their underwriting standards may be different.
“We are underwriting a consumer, rather than the collateral,” says Nelson. “So if a borrower is creditworthy for $20,000, we would lend them the money to refinance, even if they were underwater on their current loan.”
If you are in this situation and you aren’t able to find a lender willing to refinance, you have a few options.
Nelson says that the simplest move is to make additional payments that reduce your outstanding balance and bring it in line with your vehicle’s value, which would make a traditional refinance possible.
You could also take out another loan, such as a personal loan or home equity loan, and use the money to pay off your auto loan. It’s always risky using new debt to pay off old debt, but in certain situations, you might be able to secure a lower interest rate and save yourself some money.
Avoid going with the first offer
Many banks offer promotional rates as a way to get people in the door, and it may be tempting to jump on it. But there’s no guarantee the rate they’re offering is the best you can get.
“Shop around and see what different institutions offer and what their eligibility requirements are,” says Smith. “I would start with credit unions because they typically have lower rates.”
Mohr adds that there are also online companies that offer competitive auto refinance rates. You may even be able to get approved quicker by going the online route.
Don’t forget to read the fine print
When you fill out the application and accept the loan, the lender will likely ask you to read and sign several disclosure forms. Resist the urge to speed through this part of the process.
“It’s really about having an understanding of what costs come with a refinance,” says Mohr. “Different lenders are going to have different costs associated with refinancing. Are there origination fees? Are there prepayment penalties that might apply?”
In taking out this loan, you are making a financial and legal commitment to the lender. You owe it to yourself to take your time and read the fine print, ask questions, and make sure you understand what you’re agreeing to.
The bottom line
Doing your due diligence will help you figure out whether refinancing your auto loan is a good idea, and if so how you can get the best deal.
Refinancing isn’t always the best choice, but in the right situations it can lead to a lower monthly payment, save you money over the life of the loan, and get you to debt-free even sooner, making it easier to work towards your other financial goals.