Is refinancing a loan a good idea?

What exactly does it mean when you talk about refinancing a car loan? Essentially, car refinancing means taking out a new finance contract in order to pay off the existing balance of the finance agreement on your car.

In many ways, it’s a bit like when you remortgage your house to take advantage of different deals and a potentially lower rate of interest. So if you’re in a position to do so, and it will mean your payments are reduced or the overall cost of your loan is lower, then it could well be a good move.

To be able to refinance, chances are that you will need to have a good credit history and to be up to date with your payments. But is it the right move for you?

In this guide, we’ll look a little more closely at when refinancing a car loan might be a good idea for you, and when you should avoid it. Keep reading to work out whether refinancing is right for you.

When refinancing a loan is a good idea

One of the main moments to refinance a loan on a car is at the end of a Personal Contract Purchase (PCP) finance agreement. With these deals, there is a large optional final payment that you have to pay at the end of the contract to take ownership of the car. Pay this to the finance company and the car becomes yours outright, and you won’t have to return it to the lender.

What if you don't have a big pile of cash in your account to make the optional final payment, though? This is where refinancing comes in. If you want to keep your car for the long term because it’s proven to be reliable, is exactly the specification you want or you simply love it, you can refinance with a personal loan or Hire Purchase deal at this point, so you can make the optional final payment and then pay this off with another series of monthly payments.

You can also take advantage of refinancing a loan if your financial circumstances have improved or if better interest rates become available. For example, you might have a little more disposable income thanks to a work promotion, or have finished paying off another debt. These factors, or you having an improved credit score since you started the previous car finance deal, may mean that you could refinance with a better interest rate, enabling you to get cheaper monthly payments.

Alternatively, you might decide you can afford to pay more each month. In that circumstance, it might be worth considering refinancing with a shorter loan term as this should mean you pay less overall in interest, as you're paying off the finance balance more quickly.

One other potential reason why it might be worth looking into refinancing your car, is that reduced supply of new cars caused by the coronavirus pandemic, has led to a shortage of nearly new and used cars and rapidly increasing prices for second-hand cars as a result.

If you’ve had a car on PCP finance for a year or two, this means that the optional final payment may have been set before the recent jump in used car values and therefore you could refinance the remainder of the finance agreement to keep your current car, rather than having to hand it back and then looking at similar models that are likely to cost far more.

When refinancing a loan might not be right for you

If you find that your car doesn’t fit your lifestyle, then refinancing a car loan will probably not be a sensible idea. Perhaps the car’s too big, too small or has been unreliable. Or maybe it’s just that you have your eye on a different car.

In these instances, rather than refinancing your loan, you should explore the possibility of trading it in. This is possible whether you have a PCP finance contract or a Hire Purchase (HP) deal. To trade in the car you’ll need to obtain a settlement figure from your finance provider. This is the total cost of repaying a loan at that specific moment, plus any early repayment fees or other admin costs.

If you’re looking to trade the car in at a dealer, they will generally be able to do the legwork in getting the settlement figure for you. They'll give you a value that they're happy to pay for the car and you can compare this with the settlement figure, which shows how much is still owed on the car.

If you go down this route, early on in your finance contract, it’s possible that the total amount still owed is higher than the current value of the car you’re trading in. If this is the case, you will have to find the rest of the money owed to the finance company from your own pocket. If, however, the car is worth more than the amount you owe the finance company, then this can go towards a deposit on your next car.

Sometimes, refinancing a car loan can also prove more expensive than the original: for this reason, it’s important to get like-for-like finance quotes to compare any refinancing options with your current setup, as early repayment fees or other penalties on your current loan might outweigh any money you might save on the refinancing. Comparing the options this way will enable you to see if you're better off sticking with your current deal or switching.