The best way to purchase a car is to pay cash for a pre-owned vehicle. Paying in cash helps you steer clear of expensive interest charges and other loan fees. When you buy used, especially if you find a good deal, you may also be able to avoid the drastic depreciation many people experience when they drive a new vehicle off the car lot.
Although I do believe that buying your vehicle in cash is the best approach for your budget, I realize this option doesn’t work for everyone. Or rather, it takes time to prepare for such a large purchase.
I purchased my first new car in 2016. At the time, I wasn’t prepared to pay for the vehicle in cash. So, I took out an auto loan to finance it.
A solid budgeting strategy did help me pay off my auto loan just two years later in 2018. (I reached my goal of being 100% debt-free that same year.) But, looking back, I wasted a lot of money on interest and depreciation by choosing to take out a loan for a new vehicle.
Although I would have liked to turn back time and make a different decision, I had to accept where I was in my budgeting journey. That was the only way I could work to change my situation. I couldn’t wish my auto debt away. I could, however, make a plan to pay my debt off.
If you’re in a similar situation, refinancing your auto loan might help. Your eventual goal should be to pay off your debt completely. In the meantime, getting a new loan with a lower interest rate might help you to reach your financial goals more quickly.
Of course, an auto loan refinance isn’t the perfect fit for everyone. But there are three reasons why you might want to consider including this strategy in your debt payoff journey.
3 Reasons to Refinance Your Auto Loan
1. Your credit has improved.
The point of refinancing your auto loan (or any other debt) is to try to save money. If you can secure a lower interest rate on a new loan, it might help you spend less and get out of debt faster.
Lenders look at your credit when they set the price of your loan. Typically, the higher your credit score, the better the interest rate a lender will offer you. Check Credit Karma if you don’t know if your credit score has improved since you took out the original loan.
If your credit has improved, you might be able to qualify for a lower APR than you could before. Imagine the following scenario. You still owe $20,000 on your auto loan. Because your credit score was fair (659) when you took out the original 60-month loan, your APR is 9.6%. Two years later, with your new and improved credit score of 720, you qualify for a rate of 5.1%. Here’s what that lower interest rate could save you over the next four years:
- Original Payment: $503/month
- New Payment: $462/month
- Total Interest Savings: $2,010
Pay off the loan sooner than expected, and you might save even more.
2. Interest rates have dropped.
The Federal Reserve raises and lowers its benchmark interest rate from time to time. While lenders themselves ultimately decide how much to charge you when you borrow money, the rates they charge are heavily influenced by the Target Federal Funds Rate.
Have interest rates dropped since you took out your original auto loan? If so, you might be able to qualify for a replacement auto loan with a better APR. A lower APR on your auto loan can work in your favor, regardless of the cause.
3. Your debt-to-income ratio is lower.
Your credit rating is an important factor that lenders consider when you apply for a loan. But your interest rate is based on more than just your credit score.
Lenders also pay attention to something known as your debt-to-income ratio (DTI). DTI is a measurement of how much income you earn each month compared with your monthly debt payments.
When you pay down your debts, your DTI will decrease. Earning more income may improve your DTI as well. Either way, a lower DTI signals to lenders that you’re a better risk. As a result, you may be able to qualify for a new loan with a better interest rate.
How to Refinance an Auto Loan
Once you’ve done some research and decided that refinancing makes sense, there are still a few steps you should complete before you apply for a new auto loan.
Step 1: Check your credit reports and scores.
Before you fill out any new loan applications, you should check all three of your credit reports. It’s smart to review your credit scores, too, even though lenders may use a different version of your score when you fill out a loan application.
My favorite company that offers free credit reports and scores is Credit Karma.
If you find mistakes in any of your credit reports, you can dispute them with the credit bureaus. Here’s a guide that might help.
Step 2: Shop for the best deal.
After you’ve made sure your credit is in good shape, you can start to shop around for the best deal on a new auto loan. Compare interest rates from multiple lenders, and don’t forget to look for any fees that may be added on to your new loan as well.
You may be able to find a good deal on a new auto loan from your local bank or credit union. It can also be a good idea to compare rates from multiple lenders through an online loan marketplace, like Credible.
Wherever you’re ready to start rate shopping, try to limit your credit applications to a 14-day window. Credit checks (also called credit inquiries) can potentially lower your credit scores. But if you make sure any credit inquiries all occur within a two-week time frame, they’re combined together. These combined inquiries should only impact your credit scores (VantageScore or FICO) once.
Remember, when you refinance, the goal is to save as much money as possible. You should set aside enough time to research and make sure you’re getting the best deal available.
Step 3: Apply for the loan.
Once you’ve checked your credit and shopped around for the best loan, your final step is to apply. You will need to complete a full, official loan application with the lender you’ve picked.
Depending on the lender, you might need to provide copies of the following documents:
- Tax Return
- Driver’s License
- Proof of Car Insurance
When you apply, the lender will review your loan application and approve or deny your request — often right then. But some lenders may require more time or request additional documents during your application process.
If you’re approved, the lender will need you to sign your loan documents. You may be able to sign digitally if you’re applying for a loan online (like loans through the Credible marketplace). But if you’re getting a loan through a local bank or credit union, you may need to sign your loan documents in person.
Either way, once you sign the loan documents, you have officially refinanced your auto loan. The new lender will pay off your existing loan (though you should verify that it happens). From that point forward, it’s essential to make all of your future payments on time. On-time payments can protect your credit and help you avoid expensive late fees.
Want to pay off your auto loan early? This tutorial video can help you create the perfect plan to pay off your debt.