You have questions about secured loans, we have answers. Applying for a loan can feel like an overwhelming process. Before you can even apply, you have to be wary of personal factors like your credit score, debt-to-income ratio, and credit history. Then, once you start scouting the loan market,…
You need to lower your monthly car payment. What next?
The day you drive a new car off of the lot, you’re probably not expecting to have trouble making the monthly payment, but then life happens. You may lose your job or find out you’re having twins. The car payment you could once afford suddenly becomes a financial burden.
The average monthly payment for a new car is $554 and $393 for a used car. If your budget is tight, lowering your car payment by refinancing or trading in your vehicle can offer some relief.
What Is a Car Refinance Loan?
Say you have a better credit score today than you did a year ago, or car loan interest rates decrease across the market as a whole — you’re not locked into your current loan forever. A car refinance loan can get you a better loan term or interest rate, which can lower your monthly payment.
Your credit score doesn’t have to be stellar to qualify for refinancing. Some lenders are even willing to work with borrowers who have bad credit, but the terms you receive may be less competitive.
How car loan refinancing works
- Figure out how much you owe on your current auto loan. You can get a payoff statement from your current lender to find out how much you need to close the existing loan. You can also find payoff amounts on your monthly statement or online account.
- Shop around with different lenders to see what refinance options are available. Compare interest rates, loan terms, and any fees to find the best loan offer.
- Close on the car refinance loan. Once the paperwork is signed, your new lender sends a payoff check to your new lender. The title lien holder is updated to reflect the new lender. A month or so later, your first payment is due on the new loan.
There are more steps to the qualification and application process, but this is a quick overview.
What Is a Car Trade-In?
A trade-in is pretty much how it sounds — trading in a vehicle to buy another one. If you have a car you no longer love or you’re ready for a new model, the positive equity from your car is put towards the purchase of another one.
If you have negative equity and owe more on your car’s loan than the worth is worth, you may still be able to trade in your car. In these situations, the dealer may roll the negative equity into the new car loan. (More below on trading in cars with upside down loans.)
How trading in a car works
Ideally, the trade-in process starts with you doing a bit of research to find out your car’s trade-in value before heading to the dealership.
“The dealer you are trading in to is going to try and get [your car] for the lowest price available,” said Katie O’Toole Smith of Katie the Car Lady, a consumer advocate who helps customers navigate the car buying process. To get the highest price for your trade-in, Smith recommends getting the car evaluated by more than one dealership. Kelley Blue Book and Carmax are resources you can use to research before negotiating.
Once you and the dealer come to an agreement on the value of the trade-in, the price of your car is subtracted from the price of the car you’re buying, like a down payment.
Say you own a car with a trade-in value of $10,000, and you want to trade it in for a $15,000 vehicle. The dealer subtracts the price of your trade-in ($10,000) from the cost of the new car ($15,000), and then you pay the remaining $5,000, plus fees, in cash or with a car loan.
If you still owe money on the car you’re trading in, the dealer will pay off the loan to obtain the title.
Car Loan Refinancing vs. Trading In Your Car to Save Money
Whether to do a car loan refinance or trade-in isn’t always black and white. One option isn’t necessarily better than the other, but one may be better for you at the moment, depending on your goals, how much your car is worth, and your existing loan terms.
When it makes sense to refinance
If you’re happy with your car but not-so-happy with your loan terms or monthly payment, a car refinance loan will likely be the best option, especially if your credit score has recently improved enough to qualify for a better interest rate. Refinancing to a lower interest rate could offer you monthly savings.
Here’s an example:
Let’s say you took out a 66-month car loan for $20,000 with an interest rate of 10.85% six months ago when you had a credit score of 660 (a Fair FICO score). Six months later, you’ve paid off some lingering credit card debt, and as a result, your credit score has jumped up a tier to 700. After shopping around, you get approved to refinance the remaining $18,632 car loan balance with a new interest rate of 5.15%.
Using an auto refinance calculator, here’s how much you could save:
In this example, refinancing to a lower rate results in a monthly payment that is $50.82 less than your current payment and a total payment savings of $3,049.20 over the life of the loan. (Interest rates and refinance savings vary based on your credit score and other factors, such as your loan-to-value (LTV) ratio, debt-to-income (DTI) ratio, and your vehicle.)
When shopping around for a car refinance loan, remember that the monthly payment tells just one part of the story. Extending the loan term can lower the monthly payment but not the total cost. The CFPB warns that choosing a longer loan term with a lower monthly payment can lead to negative equity.
Be sure to factor in processing fees from the new lender and prepayment penalties from your current lender before moving forward with an auto refinance loan. Refinancing may not make sense if these fees add up to more than the savings.
When a car trade-in makes sense
If you have a car payment that is currently stretching your budget thin, you may also consider trading down. Downsizing to a lower-priced make, model, or size could bring your payment down lower than you’ll get by refinancing your current car loan.
A trade-in may not make sense if you cannot find a dealer that offers you a decent trade-in value. In some instances, you may get a better price selling to an independent buyer and then using the funds from the sale to purchase another car.
If you can, avoid rolling over your previous loan balance into a new loan. That will just put you upside down on your loan from the start, leaving you financially vulnerable.
Refinancing vs. Trading in a Car When Upside Down
Being “upside down” or “underwater” means that you owe more for your car than it’s worth. In other words, your vehicle is depreciating faster than you’re paying off the loan.
Car loans are secured loans; your car is the collateral that lenders can use to secure the loan. The collateral, your car, protects them in the event that you stop making payments because they can repossess the vehicle and sell it to recoup costs.
However, when you’re upside down, that loan amount over the value is unsecured. There’s no more collateral. This leaves you on the hook for the remaining loan balance if you sell your car or it’s declared a total loss after a wreck.
To determine if you’re upside down, divide your loan balance by the car’s value and multiply by 100 — this is your loan-to-value (LTV) ratio. Try the loan-to-value calculator below:
Car (LTV) Loan-to-Value Calculator
If your LTV is over 100%, you’re upside down. The dollar amount you owe above what your car is worth is called negative equity.
Refinancing while upside down on a car loan
Refinancing or trading in a car can be tricky when you’re upside down, but not impossible. Lenders may be hesitant to lend you more money than your car is worth because of the risk. If you stop making payments and the lender takes the car, there’s not enough equity to cover the entire loan balance.
A lender may be open to refinancing if your loan-to-value ratio is under 125%. You’ll likely have a tough time qualifying for an auto refinance loan if you have an LTV over 125%, especially if you have bad credit.
One of two things usually happens if you trade in a car that’s underwater: You pay the negative equity in cash, or you roll the negative equity into the loan for your new car. Keep in mind that rolling negative equity into a new loan means you may be upside down on the new car before even driving off the lot.
Credit also matters in this situation: “Typically, lenders have a sliding scale of max loan-to-value based on FICO score. The higher the FICO score, the higher amount of negative equity the lender will finance without the customer needing to put a down payment,” said Joel Benavides, Consumer Credit Manager at RateGenius. More and more lenders are willing to approve higher LTV loans, but negative equity will likely lead to a more expensive loan so be careful.
Don’t get too excited if you see a dealership ad promising to pay off the negativity equity for you. The Federal Trade Commission (FTC) warns that trade-in “deals” like this are usually too good to be true. Instead of paying off the negative equity, the dealer will likely roll the balance into the new loan as mentioned above. Read the financing disclosures carefully to avoid getting duped.
Is It Better to Refinance or Trade In Your Car?
Choosing whether to refinance or trade in isn’t one-size-fits-all. You’ll have to consider the terms of the refinance loan you qualify for and the value of your trade-in to decide which option is the right move.
If your main goal is to lower your monthly payment, shop around for car loan refinancing to see what monthly savings you can get with a new loan. After that, research the value of your car and explore trade-in options to see if you’re able to get an even lower payment with a different one. Then compare the two scenarios to determine which one will be better for your family.