So I got a car recently, and the dealer and my parents agree that refinancing will be a good idea soon. How does it make sense for another creditor to buy your credit and give you a better rate? Why would the original creditor not just keep you on the hook for the worse rate?
In: Economics
The original lender gets the money lump sum. Though they don’t get a choice if the 2nd lender just lends you the money to pay off the original loan directly.
The original creditor would keep you on that high rate if they could. Worst they can do is impose an early loan payoff fee.
Let’s start backwards. Most loans don’t have early repayment penalties—you can pay back the entire remainder of the loan whenever you want. They can’t just “keep you on the hook.”
Now, if I go to a different bank from my current lender and they give me a loan at a lower rate to pay off my current loan, that’s a refinance in a nutshell.
So now, my original lender knows I can do this. So rather than lose ALL of the interest I will be paying over the remainder of the loan, they decide to lose just SOME of it by letting me refinance with them.
There are usually (sometimes significant) fees associated with refinancing, so it doesn’t always pay unless the rate drops enough.
Lender 1 gets paid in full without risk after hav8ng extracted origination fees for the new loan. They can turn around and lend that money to someone else, extracting more fees from the new borrower and then having interest paid to them.
Lender 2 gets origination fees, a new customer, collateral, and interest payments.
You get a more favorable payment term that hopefully saves you more than the origination fees on the new loan.
There’s two main factors at play. When you loan someone money, there’s a risk they won’t pay you back. And, in the US, when you make a payment on a debt the payment is applied to interest first, with any remainder going to your principal (the amount you actually owe). Since your payment amount doesn’t change, the majority of your early payments only pay for accrued interest on your balance, with principal payments coming later down the line.
From the bank’s point of view, they collect their interest up-front, then get paid off when you refinance. They get their money back and no more risk of default. It’s an easy yes from them.
For you, the person taking out the loan, you might want to refinance to get a better rate, and possibly to change the duration of the loan. A better rate means you pay less interest, obvious win there. Changing the loan duration to be shorter means bigger payments each month but less money spent on interest overall, that might be appealing if you’ve got a bit more money to spend each month. Changing the loan duration to be longer probably means more interest overall, but smaller monthly payments, which might be necessary for you if you’ve got less money to spend each month.
For the initial creditor, if you’re refinancing with someone else, the initial creditor might not really have any say in it, assuming the new creditor pays off that initial loan. Basically you’re taking out a new loan with a different creditor, and using the money they gave you to pay off that initial loan. Generally the terms of the loan will allow you to pay the whole thing off early if you want to and you have the money to do so.
But also, depending on market conditions, that initial creditor might agree to refinance your loan themselves, rather than risk you finding a new creditor. The initial creditor then might get less interest over the lifetime of the refinanced loan than they would’ve gotten from the original terms, but that’s still more than the zero they’d start getting if you moved to a new loan with a different creditor.
I don’t know if there are any ways to disable the post once it’s answered. But I do get it now. Thanks everyone
>Why would the original creditor not just keep you on the hook for the worse rate?
Because you generally can pay off your loan at any time. It almost never galena that you have any early payoff penalty. So the original lender can’t stop you from paying it off early.
You could buy a new car by getting a loan, then come into enough money to buy it for cash a month later, and they can’t stop you from paying it off.
So the new lender gives you a better rate. They now get your monthly payments and the interest in the loan until such time as you pay it off early or at the end of the loan.
The key here is that there is no penalty for paying off a loan early. If there is, then yeah, refinancing likely isn’t your best option.
> How does it make sense for another creditor to buy your credit and give you a better rate
– It sounds like you’re a young person just starting out. If you have little-to-no credit history, your credit score might improve a lot after having a car loan for 6-12 months with no late / missed payments.
– General interest rates might be lower for whatever reason.
– Even if the interest rate is the same, a refinance might still give you lower payments that continue for a longer time [1].
> Why would the original creditor not just keep you on the hook for the worse rate?
Read your loan contract. It probably says you can pay off the loan early without penalty. Why do they put that in the contract? They might have to (due to laws / regulations), plus expectations (people expect to be able to do refinancing / early repayment of loans so if your loan contract doesn’t allow that, people might complain and you’ll find it hard to get new customers.)
[1] This one needs some explaining, so here’s an example:
– The day you bought your car, you borrowed $10,000 (with no interest, for simplicity) from the Bank of Alice. You pay Alice $2000 a year for the next 5 years.
– You then refinance in two years: You borrow $6,000 from the Bank of Bob, and use that money to pay off your remaining $6,000 debt to Alice immediately. You then repay Bob $1200 a year for the next 5 years.
– Your payments are: (2024: $2000, 2025 : $2000, 2026 : $1200, 2027 : $1200, 2028: $1200, 2029: $1200, 2030: $1200).
– Alice gets $2000 in two years (2024 and 2025), then she gets $6000 in a lump sum at the beginning of 2026 (that’s the $6000 you borrow from Bob when you refinance in 2026).
– Bob gets $1200 in 2026-2030.
Someone is willing to make less money by offering you a loan at a lower interest rate. The original loan person is going to be upset they’re losing out on profit by the loan ending early for them. But it’s pretty uncommon they can do anything to stop this. TBH I wouldn’t be surprised if early payoff penalties are legally disallowed on a lot of debt products.
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