Refinancing your car loan can lower your interest costs and monthly debt payments. While it usually hurts your credit score, the damage is rarely significant, and your credit should recover quickly.

Let’s explore the process further to help you decide whether it’s worth pursuing in your circumstances.

How Does Refinancing an Auto Loan Work?

Auto loan refinancing involves taking out a second loan and using its proceeds to pay off the remaining loan amount on the initial account. Then, you start making monthly payments to the new lender according to the revised terms.

Getting the second auto loan works very similarly to getting the first. You’ll need to complete an application, including a credit check, which influences your new interest rate. It’s a good idea to apply with a few providers to get the best deal.

Borrowers usually refinance their auto loans to reduce their interest costs or to get a lower monthly payment, depending on whether they prioritize saving money in the long or short term.

In ideal circumstances, you can accomplish both to some degree. However, you can only minimize one because lowering your monthly loan payment as much as possible means extending your repayment term, giving interest more time to accrue.

For example, you take out a 60-month auto loan for $25,000, with an 8% annual interest rate and a $507 monthly payment. After 24 months, you have an outstanding balance of $16,176.

Fortunately, interest rates have fallen in the last two years, and you’ve established a good credit score. You take the opportunity to refinance your existing loan and receive an offer for a 5% interest rate, with either a 36-month or 60-month repayment term.

The 36-month option would save you $795 in interest by the end of the loan but only shave $22 off your monthly payment. Meanwhile, the 60-month option would reduce your car payment by $202 but increase your interest costs by $67. 

How Refinancing a Car Loan Affects Credit

Your credit score is the result of a formula that involves the following five factors:

• Timeliness of payment history
• Level of outstanding debt
• Diversity of credit account types
• Age of credit accounts
• Number of recent new credit inquiries

Refinancing a car loan can affect most of these, though some only indirectly. Let’s go through the process step-by-step to illustrate how.

First, car refinancing requires you to undergo a credit check as you apply for the new account. That adds a hard inquiry to your credit report, which damages your score slightly, depending on how many others you’ve incurred lately.

Once you receive approval for the new account, you’ll use its proceeds to pay off and close the old one. That lowers your newest account age and average account age, both of which also reduce your score. Fortunately, you’ll start seeing benefits after that.

If you refinanced because you were struggling with your monthly payments, lowering them will help you make them on time. If you refinanced to reduce your interest costs, you can accelerate the pace at which you reduce your debt balance.

Either way, your score should improve as you make timely payments. Payment history and outstanding debt balances are the two most significant factors in your FICO score, worth 65% combined.

The time required for the age of your credit accounts to recover varies, but the hard credit inquiry will stop affecting your score after 12 months. Finally, the credit bureau will remove it from your credit report entirely after 24 months.

What Is a Good Reason To Refinance a Car?

An auto loan refinance can be beneficial, but it’s not for everyone. Let’s explore the best reasons to consider one.

Interest Rates Are Going Down

Decreasing interest rates is one of the best reasons to refinance your car loan. It presents an opportunity to reduce your financing costs significantly, regardless of your credit score.

For example, say you have an auto loan with $20,000 outstanding and 36 months of payments left. Your current interest rate is 12%. Reducing it to 7% would save you $1,683 by the end of the repayment term.

Your Car Is Retaining Value

Cars tend to depreciate rapidly, but there are exceptions. You may be able to take home some extra money by executing a cash-out auto refinance if yours retains its value better than expected.

For example, say you have a car worth $18,000, and your current loan on the vehicle has a $10,000 balance. As a result, you have $8,000 of equity in the car.

However, lenders usually loan up to 80% of the asset’s value, so you can only qualify for a $14,400 loan. You use it to pay off the original and pocket an extra $4,400.

That strategy can help you generate extra cash, but your debt balance will increase. Depending on your new interest rate and repayment term, it can also increase your interest costs and monthly payment.

Increase in Credit Score

A credit score increase can be another opportunity to reduce your financing costs significantly. Going from 600 to 700 will lower your interest rate on a used car loan from 16.85% to 5.53% on average in 2022.

Fortunately, your score should improve if you make your auto loan payments on time for a year or two. If you’re not already monitoring it regularly, check whether it’s gone up once you’ve had your auto loan for a while.

Learn More: Credit Score Statistics

You Need Money

Refinancing an auto loan can often be beneficial when money is tight. The easiest way to free up cash using the transaction is to refinance into a longer loan term, reducing your monthly payment.

However, you can also generate a lump sum with a cash-out car refinance if you have equity in your asset. To calculate your equity, subtract your remaining loan balance from its current market value.

You Want To Add or Remove a Co-Borrower

If you have a bad credit score, lenders will give you a higher interest rate or decline to work with you altogether. One way to get around that issue is to apply with a co-borrower or co-signer with a better credit history.

These individuals share responsibility for the debt, giving some assurance to the lender. You may want to refinance to add one and get a better interest rate or remove one to release them from their financial obligations.

When Refinancing Doesn’t Make Sense

In the right circumstances, refinancing can help you lower your financing costs or monthly debt payments. However, these aren’t always possible, and the tactic usually doesn’t make sense if it doesn’t provide either of those benefits.

The most common reasons you’ll find it hard to lower your financing costs are that interest rates have increased or your credit score has decreased since the start of your original loan term.

Not only will you struggle to qualify for a lower interest rate in these situations, but you may not even be able to get a loan at all if your score decreases too much. In that case, you won’t be able to reduce your monthly loan payments either.

Refinancing may also be more trouble than it’s worth. Not only does it damage your credit score for a while, but it also takes time and energy to get a new loan. You may even incur charges such as early termination or title transfer fees.

How Long Could My Credit Score Be Affected?

A refinance shouldn’t negatively affect your credit score for very long. Any damage from the hard inquiry is guaranteed to disappear after 12 months, and it’s likely to vanish before that since it’s usually less than 10 points.

The damage to your score from closing the old loan and opening the new one is more variable. It will be most significant if the original loan was your oldest credit account and you have few others.

However, the age of your credit accounts is also a relatively insignificant aspect of your score, worth only 15%. If the refinance helps you improve your payment history or reduce your balances, you should recover almost as quickly as from the hard inquiry.

How To Limit the Hit to Your Credit Score

Refinancing will inevitably damage your credit score somewhat, but it doesn’t have to be significant. In fact, you can help reduce the damage to your score if you complete the process strategically.

The two primary ways that refinancing hurts your credit score are by triggering hard inquiries and lowering the age of your credit accounts. There’s not much you can do about the latter at the time of refinancing, but you can minimize the effect of the former.

Most importantly, keep all your applications for refinancing within the rate-shopping grace period. All credit inquiries during that window count as a single instance. You’ll still lose some points, but you won’t have to suffer damage for each loan application.

Unfortunately, the window varies between credit scoring algorithms. It’s 45 days for the latest FICO score versions, but it’s only 14 days for the older versions and VantageScores. It’s best to stick to the shorter window to be safe.

Can I Refinance With Bad Credit? 

Refinancing a car loan with bad credit is possible, but it’s usually only beneficial if you still qualify for a lower interest rate. That may be difficult if your credit is worse than when you took out the original loan.

However, you could receive a better offer if interest rates have dropped overall, especially if the decrease in your score was relatively slight. It’s also likely if your credit was worse when you took out the original loan, even if it’s still poor now.

If your credit is low, you can improve your chances of qualifying for a favorable refinancing option by applying with a creditworthy co-borrower or co-signer. Shop with multiple lenders in any case, but keep your applications within a two-week window.

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