Eric Gillin

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Steer Clear of Auto-Loan Refinancing

Eric Gillin

Refinancing -- it's not just for homeowners anymore.

Over the past few years, car owners have also taken advantage of declining interest rates and refinanced their auto loans at lower rates. But in doing so, many have kept themselves on the debt treadmill, opting for a little monthly savings at the expense of higher costs over the life of the loan.

"It's on the rise -- 450,000 people will refinance their car loans this year, nearly three times the 172,934 people who refinanced in 1999 and 297,363 who refinanced in 2001," said Art Spinella, vice president and general manager at auto-market researcher CMW. "The low interest rates are a key part of the increased demand."

As of last week, the average national rate on a 36-month used car loan was 9.12%, according to Bankrate.com, the lowest it has been in the five years has tracked auto loans. Two years ago, the same loan had a rate of 10.82%.

But because a car can depreciate as much as 20% from the second you drive off the lot, it's in your best interest to pay off the car as cheaply and quickly as possible -- something many refinancers never take into account. Instead of using the low rates to pay off loans in a hurry -- a useful exercise -- many auto refinancers opt to extend the terms of their loan, which reduces monthly payments but increases the total interest paid.

"The current monthly payment, on average, is $517. For people who refinance, their new loan has a monthly payment of $410. But nothing has really changed," said Spinella. "They just stretched out the amount of time they had to pay off the loan. On average, they extended their loans by 28 months, basically adding two years."

When Refinancing Doesn't Work

Let's say you purchased a car two years ago and got a 60-month loan with a rate of 8%. Today, you've got 36 months left, a loan balance of $10,000, and a monthly payment of $313.36, which you'd like to refinance to save some money. While the allure of lower monthly payments is strong, remember that it costs you in the long run.

Let's take the $10,000 balance and refinance it into a 6.55%, 72-month loan currently offered by PeopleFirst.com, an online lender. Thanks to the new rate and longer term, you'll have a monthly payment of just $168.34.

But while the new payment is half as much, your loan term is twice as long, which means you'll pay $12,120.30 over the life of the loan. If you did nothing and stayed with the 8% loan, you'd only pay $11,281.09 -- about $850 less. [See below.]

"The environment is very conducive for refinancing, but in the case of auto refinancing, it's not something that works for most borrowers," said Greg McBride, financial analyst at rate-tracker Bankrate.com. "Auto refinancing only generates tangible savings given two things. One: A tangible reduction in the interest rate. And two: Not extending the term of the loan."

So don't be fooled by the rates. While there is a 250 basis-point difference between the original 8% loan and the 5.49% refinancing offered by PeopleFirst.com, you'll save just $11.45 a month on payments and slightly more than $400 over three years -- and that's without extending the loan term. Add another two years and you'll pay more.

When Refinancing Can Make a Difference

The people who benefit most from an auto refi, the experts say, are those who received extremely unfavorable rates because of a poor credit history when buying a car a few years ago. "A good scenario is someone who has borderline credit, maybe a young person who bought a car and had to finance at a high rate," said Phil Reed, consumer-advice editor at Edmunds.com, who adds consumers can get better rates because "car dealers have a big markup on the financing they sell -- sometimes by 4% or 5%."

Once you get above 10% for a car loan, it's a different ballgame. If you had $10,000 at 14% with 36 months left and could get into a 7% with the same terms, you'd save $33 a month and nearly $1,200 over the life of the loan. Clearly, refinancing would be a no-brainer.

Or, look at the example shown in the table below. A lower rate may reduce your monthly payment, but that doesn't mean you should spend the difference on fancy dinners. Instead, apply the difference in your payments to the loan balance. You'd pay off the loan in 33 months instead of 36 months and save even more on interest costs. An even better bet -- use the monthly savings to pay off that credit card.

"People who are two years into a five-year loan tend to benefit most because of the way rates have fallen and because they still have a sizeable amount left to pay," said Reed.

And unlike refinancing a home, there are few fees (if any) associated with refinancing an automobile. "The only cost is to retitle the car in whatever state you're in and that's about $25. And unlike a house, it's extremely easy. You don't need to get the car reappraised or fill out tons of paperwork," said Joe Kennedy, president of online lender eLoan.com.

Figuring out if it works for you is a snap. Bankrate.com and Edmunds.com both have excellent calculators that allow you to see how rate, time and payments can affect the total interest you'll pay.

Just remember to look at the bottom line, not the monthly payment. "We're living in a climate where people are tempted by short-term gains. It's so easy to get into a new car with those 0% financing deals out there," said Reed. "But these banks and automakers know what they're doing. You'll usually end up spending more in long run."