Why Car Loan Refinancing Is a Bad Idea

You might think you can boost your cash flow by refinancing your car loan.

But such a move might not improve your cash flow by as much as you might think --- and it also could increase the term and overall costs of the loan.

"There just aren't a lot of situations where refinancing an auto loan makes sense," says F. John Deyeso, a certified financial planner in New York City.

One problem: Autos tend to depreciate rapidly -- typically about 45% in the first three years, according to Consumer Reports. The value of your car is likely to decline faster than the principal you owe, leaving you with an "upside down" loan, meaning you owe more than the car is worth.

If you refinance the car when your loan is upside down, the new lender may demand an upfront cash payment equal to the difference between the car's value and the amount you owe.

What's more, amortization begins anew with a new loan. This means your early payments will cut into interest much faster than principal -- and you might be saddled with another upside-down loan.

Beyond all that, you may find your payments won't fall much, unless you take on more payments. And borrowing money over longer periods is expensive.

Let's say you took a five-year, $25,000 car loan a little over two years ago at an interest rate of 8%. With a monthly payment of $507, you'll lay out $30,415 over the life of the loan.

After 27 payments (a total of $13,687), you'd owe about $15,000 in principal. Paying off that $15,000 would cost you another $16,728 over 33 remaining payments.

You might lower that cost by refinancing at a lower rate. But the savings might not add up to as much as you'd think -- especially if the new loan has a longer term than your current one.

The table below, based on data from BankingMyWay.com, shows the monthly payments and total cost of an old, relatively high 8% loan with 33 payments remaining. It also shows how much those figures would change if you refinanced at some of today's lowest available rates from a credit union and a bank. Like used-car loans, refinancing rates are typically higher than for a new car.

Cost of a $15,000 auto refinance loan
Interest Rate Term (months) Monthly payment Total cost
8% (current loan) 33 (remaining) $506.91 $16,728.03
4.25% 36 $444.53 $16,003.08
4.25% 48 $340.37 $16,337.76
6.29% 36 $458.30 $16,498.80
6.29% 48 $354.00 $16,992.00
Source: BankingMyWay.com calculator

A 36-month loan at 4.25% would cut your payments by about $60 per month, and the total costs by about $700. Over 48 months, the payment drops to $340.37, but you'll save less than $400 over the life of the loan. The 6.29% loan would cut your monthly payment by less than $50 and save you less than $250 over the life of the loan.

What's wrong with saving $250? Nothing. But after you factor in fees, which are typically very low, you might actually end up spending more money than if you had stuck with your old loan, especially if you have to make an upfront cash payment to the new lender (to make up for an upside-down loan).

The Home-Equity Alternative

You could take out a home-equity loan or line of credit to pay off your car loan. But that might not be such a wise move either. Say you got a 5.99% rate. Paying back the original $15,000 would cost more than $18,600 over the life of a five-year loan. It gets worse if you take a longer loan.
Home equity/refinance
Interest Rate Term (months) Monthly payment Total cost
8% (current loan) 33 (remaining) $506.91 $16,728.03
5.99% 60 $310.22 $18,613.20
5.99% 180 $126.50 $22,770.00
5.99% 360 $89.84 $32,342.40
Source: BankingMyWay.com calculator

Are there any circumstances when refinancing a car loan makes sense? Sure. Maybe your credit score was terrible when you bought the car, saddling you with a sky-high interest rate of say, 10.5%. In that case, a sharp rate reduction could result in significant savings.

That sort of situation is rare.

"Refinancing a car loan probably isn't a great idea unless you're really desperate for cash flow," Deyoso says.

Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.

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