While auto refinancing can be a quick and easy process, there are still several pitfalls you should aim to avoid. Because the process is so easy, some rush into a refinance loan for their vehicle without a second thought. But you are still entering into a loan agreement and you should be careful when doing so.
Here's what you need to avoid;
1. Taking out too long of a loan term
Some car owners will jump at the chance to extend their loan term to lower their payments. While paying less each month to your lender seems to be a good deal, there are several disadvantages to doing this. First, you could end up in an upside down car loan. An upside down car loan is when you owe more on the car than it is worth. A vehicle loses anywhere from 15-20% of it's value each year. If you extend your loan, you could very easily end up in an upside down vehicle loan.
The second disadvantage in refinancing your vehicle for a longer loan term is the amount of interest you will pay over the life of the loan. Let's assume you bought a $20,000 vehicle and financed it for five years at 6.5%. At the end of year two, you decide to refinance for another five years to lower the payment. You again get a 6.5% interest rate.
| ||Original Loan ||New Loan |
|Loan amount ||$20,000 ||$13,088.41 |
|Payment ||$391.32 ||$256.09 |
|Interest paid over life of loan ||$3,479.43 ||$2,276.96 |
|Interest paid 1st two years ||$2,088.77 ||------------ |
|Additional interest to pay ||------------ ||$886.30 |
When you refinance, you have already paid $2,088.77 in interest on the original loan. By refinancing the vehicle for five more years, you will now pay an additional $2,276.96 on the new loan for a total of $4,365.73. If you had kept the original loan for five years, you would have paid only $3,479.43 in interest for a difference of $886.30. In all likelihood, the difference would actually be greater because your interest rate for the second loan would be higher because it is for a used car.
2. Refinancing when you're close to payoff
As with any loan, your payment is applied first to interest and then to principal. Of course with a higher loan amount, the interest due is higher. This results in the majority of your interest being paid in the first few years of the loan.
If you decide to refinance your vehicle when you are close to payoff, you will end up paying even more in interest. On a $20,000 loan, you will pay just over $160 in interest for the last year as opposed to almost $1,200 in the first year of the loan. You do not have anything to gain by refinancing your loan when you are close to payoff. You are much better off to stick it out with your current loan even if the payment is a little higher.
3. Signing a loan with penalties
Whenever you sign any loan documents, whether for an auto, a house or otherwise, you should always read your loan documents carefully. Hidden in the tiny print could be several clauses that can cost you quite a bit of money down the road.
The first of these is a prepayment penalty. If this clause appears in your loan documents, you could have to pay a penalty if you pay your loan off early. This includes if you decide to refinance. Some lenders will charge a flat fee but most charge a percentage of the loan amount. Keep in mind the prepayment penalty can apply if you decide to add a little to your payment each month to pay your loan off early. Anything above and beyond a regular monthly car payment will impose the penalty.
Another common penalty is an increase in interest rate if you miss a loan payment or you make a late loan payment. Again, this varies by lender. Some are very strict and with the first late payment, your interest rate could increase to 18% or more. On a $20,000 loan, that increase can add more than $100 a month to your loan payment and the extra interest charges will be in the thousands.
These penalties can usually be negotiated out of your loan documents if you are faced with them when you sign your loan. Be sure to speak up or it could cost you in the future.
4. Getting a variable rate loan when rates are on the rise
Variable rate loans typically offer a lower rate than a fixed rate loan, at least in the beginning. If interest rates are on the rise or if you are already at your maximum payment with your current interest rate, you should reconsider taking out a variable rate vehicle loan.
With variable rate loans, the interest rate adjusts according to an index. Depending on your loan, the rate could adjust as much as once a month or as little as once a year. Many offer interest rate caps but even with the cap, the interest rate could make your auto payment higher than you can afford.
When interest rates are expected to rise, it is best to get a fixed rate for the term of your vehicle loan. This way, you know upfront exactly what your payment will be each month. There is considerably less risk involved in a fixed rate auto loan.
5. Signing for a pre-computed loan instead of a simple interest loan
First, a simple interest loan is the most common way to compute interest. In this loan, the interest is accrued daily based on the balance of the loan. A simple interest loan results in less interest paid than a pre-computed loan. Understanding a pre-computed loan can be difficult and involves quite a bit of math.
With a pre-computed loan, the interest is figured up-front and added to the principal amount. For a $7,000 loan at 8% for four years, the interest would be $2,240. It is figured as Loan Amount x Interest Rate x Loan Term in Years. The payment on this loan would be $192.50 ($7,000 principal + $2,240 interest / 48 months). The same loan using the simple interest method would result in $1,200 in interest and a monthly payment of $170.89.
What can compound this even more is if the lender uses the Rule of 78s. The number 78 is simply the numbers 1-12 (12 for the number of months in a year) added together (1+2+3…). For a four-year loan, you would add 1-48 (48 being the number of months in the loan) together resulting in 1,176. With the Rule of 78s, you pay the most amount of interest in the beginning of the loan.
In month one, 48/1176 x $2,240 = $91.43. This is the amount of your payment that would be applied to interest. On the simple interest loan, only $46.67 would be applied to interest resulting in paying down the principal portion of the loan quicker. In month two, it would be 47/1176 x $2,240, etc.
It is very easy to end up in an upside down loan when your lender uses the pre-computed method. It is rare to find a bank that will use any method other than simple interest. However, you may run across it with a finance company and you should avoid this method.
6. Paying unnecessary high interest rate due to wrong information
When you have a credit report with a few blemishes, your interest rate can vary greatly from the person who has perfect credit. It is very important to get a copy of your credit report before you go shopping for a loan to be sure everything on it is accurate. There are lenders out there for borrowers with different credit histories but you shouldn't pay more than you have to because of errors.
You can obtain your credit report once a year for free by contacting the credit agencies. It would be wise of you to do this before shopping for a loan. If you do find inaccuracies, contact the credit agencies immediately and find out what their process is to remove the incorrect information.
Refinancing your auto loan can be a simple, fast, no cost way to save money. These tips should help you to avoid the mistakes and reap the benefits of a lower monthly payment or shorter car loan term.