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Don’t rush to refinance your car loan — or wait too long.
If you’re a first-time car buyer, you might not be familiar with auto loan refinances.
Refinancing your auto loan can be a prudent financial move. The primary goal after all is to save money.
Ideally, your new loan will have a lower interest rate, thereby lowering your monthly car payment and reducing your total interest. You can then use the extra cash to pay down your loan faster, build up savings, or cover some other financial need.
But how long should you wait to refinance your car loan? Does it even matter?
Spoiler alert: Yes, it matters.
While there’s no set industry standard, it’s usually best to wait between six months and a year before pursuing a car refinance loan. That said, you could refinance immediately after buying a new car — but you might not see the greatest benefits.
For starters, refinancing too soon may not give your credit score enough time to recover from the original purchase. When you apply for a loan, lenders often pull your credit report, which generates a hard inquiry. It’s a necessary step in the process, but it does affect your scores — temporarily, at least. (With that in mind, you might be able to prequalify without generating a hard credit inquiry.)
So, if you had average or even bad credit when you took out your original loan, your updated scores might not be enough to help you qualify for refinancing.
Perhaps more importantly, you might not be able to find a new lender right away. Financial institutions typically want to see six months to a year of timely car payments from auto loan borrowers. In other words, lenders want to see that you’re reliable and less of a risk before they extend you a new loan.
While it’s possible for you to find a lender willing to extend you a new loan immediately, you’d likely have to shop around.
So, when should you look to replace your current car loan with a new one? There isn’t a one-size-fits-all answer to this question. Once you’re six months or even a year into the life of the loan, you’ll have an easier time finding willing lenders — but is it the best time for you?
Let’s explore some indicators that it’s the right time to refinance your car loan.
People with excellent credit have a higher chance of getting approved for the best loans. Alas, not everyone has excellent credit.
Maybe you had limited credit history when you first drove off the lot. Maybe you carried a high balance on your credit cards at the time. Regardless, if you’ve improved your scores, then it could make sense to explore refinancing.
Interest rates change. The Fed Funds Effective Rate has jumped 2.25% in 2022 alone. This upward movement has and will trickle down to other types of loans, from mortgages and personal loans to auto loans and refinance loans.
That said, rates can come down just as easily as they can rise. If and when they do, you could take advantage and refinance at a lower rate — assuming you qualify.
Credit scores are important, but they’re far from the only thing lenders consider. Your loan-to-value ratio (LTV) measures your outstanding loan against your vehicle’s dollar value, expressed as a percentage. For instance, if your car is worth $10,000 and your loan amount is $8,000, then your LTV would be 80%. In this case, you’d have positive equity in your car.
On the other hand, if you flipped these numbers — an $8,000 car and a $10,000 loan — your LTV would be 120%. You’d have negative equity in your car and would be upside-down on your loan.
According to RateGenius’s 2022 State of Auto Refinance report, the average LTV of borrowers who successfully refinanced in 2021 was 93.1%. So, if you’re around or below this figure, you should be in good shape.
Your debt-to-income ratio (DTI) is a critical factor that lenders evaluate when making loan decisions. This metric compares your monthly debt payments to your monthly income. In other words, what percentage of your debt is committed to obligations like credit card bills, a mortgage, student loans, etc.
If you recently benefited from an income boost, such as a promotion or part-time gig, your DTI should improve. (Unless your debt payments increased proportionally.)
Mortgage lenders usually prefer to see a DTI below 36%. That’s not a hard-set rule in the auto loan industry. Generally speaking, a DTI of 50% is a good benchmark to stay below — but the lower, the better.
Taking out a new loan isn’t necessarily an intuitive process. There are a lot of factors at play that borrowers need to consider. So, let’s explore five mistakes you can avoid during this process to improve your chances of not only qualifying, but getting the best terms and saving the most money.
Loans can have prepayment penalties, which are fees you incur by paying back your loan too soon. This can be an eyebrow-raiser — why would a lender ever penalize you for early repayment?
Prepayment penalties are a particularly common clause in subprime loans (i.e., loans to borrowers with bad credit). To offset the risk of issuing loans to people with bad credit, lenders charge higher interest rates.
The interest you pay on top of your principal payments is essentially the lender’s profit. It’s what compensates them for lending money in the first place. So, when you pay off your loan early, you not only lower your total interest costs but also your lender’s interest income.
Hence why some lenders discourage early repayment by issuing a penalty.
Most cars depreciate; it’s a fact of life. But if your car has depreciated faster than you’ve paid it off, you could have a hard time qualifying for a refinance loan. Or, at least, one with better terms.
While the average LTV of borrowers who successfully refinance is 93.1%, some lenders are willing to give you a little more wiggle room. It varies, but it’s possible to find an LTV max of 125% to 130% of a vehicle’s retail value.
That said, having negative equity in your car can lead to trouble. Beyond owing money if you ever decide to sell, you could find yourself in a financial pickle if you’re ever in an accident, as your insurance payout would likely be less than your outstanding balance. (That’s where GAP waivers come in handy.)
Just as there’s a time when it’s too soon to refinance, there can also be a time when it’s too late to refinance.
Imagine you’re already several years into your existing loan. Do you really want to extend your term another four or five years? Let’s run through a quick example.
Assume you took out a 60-month, $22,500 loan with an interest rate of 7%. Three years into your loan, you’d have an outstanding balance of roughly $10,000. Now, let’s pretend you refinance into a 48-month loan with a lower rate of 5%.
While your monthly payment would drop by about $215, your total interest costs would be $305 more than if you just stuck with your initial loan. Perhaps the lower monthly payment justifies the additional interest charges overall though — that’s a subjective financial decision.
Even when personal finances are tight, it’s never wise to skip or inadvertently miss payments. On top of possibly incurring late fees, you could also hurt your credit score, which could make it harder to qualify for auto loan refinancing.
While the exact weighting varies by credit scoring model, your payment history is typically the most important factor in determining your scores. Even one missed payment can have drastic implications — potentially as much as 180 points according to FICO data.
If you’re struggling to make ends meet and think you’re on the verge of missing a payment, start by reaching out to your lender to discuss your options.
When you refinance your auto loan, you may push out your loan’s maturity date. For instance, if you’re six months into a 60-month loan, you have 54 months remaining. If you take out a new 60-month loan to refinance your current one, you’re effectively extending the life of your loan.
Extending your loan term can be a mistake — but not always. A longer term may ultimately cost more since you’re paying interest longer. So, it depends on your new interest rate and how fast you repay your balance. On the other hand, the savings could outweigh the cost, not to mention the lower monthly payment.
Everyone’s financial situation is unique. That said, there are a few steps every borrower should consider taking before applying for a new loan.
It’s prudent to keep tabs on your credit report regardless, but it’s especially important to check your credit before you apply for a loan or credit card. First, you could have an error that’s hurting your scores. Second, you’ll want to know where you stand.
While it varies by lending program, 670 was the average credit score of borrowers who successfully refinanced by using RateGenius’s marketplace in 2021.
If you have excellent credit, great. If your scores could use some work, well, now you know. Otherwise, if you apply and get rejected or don’t qualify for a better interest rate, then you’ve not only wasted time but likely dinged your scores. (Applying for loans generates a credit inquiry, which is a small but important scoring factor.)
While this isn’t in the cards for everybody, you could significantly improve your chances of qualifying for a refinance loan by paying down your debt. That could be your current auto loan or a credit card with a high balance.
By paying down your auto loan, you improve two key metrics: your DTI and your LTV.
On the other hand, you could take another route and pay down credit card debt. Comparatively, credit cards usually charge higher interest rates — so reducing your balance can help save money in the long run.
Moreover, you’ll lower your credit utilization ratio. This measures your total credit balance against your total credit availability, and it usually represents the second most important credit scoring factor after payment history.
Just as you’d check out multiple dealerships for the right car, it’s equally important to shop around for the right refinance loan. Lending programs vary, from their credit score minimums to their auto loan rates and terms. Consider using a marketplace to compare multiple refinancing options at once.
Let’s review. Here are three main things to consider before you apply.
Improving your credit score gives you the best chance of locking in better rates and terms when you apply to refinance your auto loan. As does lowering your overall credit utilization.
As for when to apply, there’s no hard-set rule, but lenders typically prefer to see at least six months of payment history. On the other hand, waiting until you’ve paid off most of your auto loan could negate the cost savings of refinancing, as you’d likely pay more in total interest over the loan’s lifetime.
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