Luis Valdez Jimenez - The Penny Hoarder

Like many young professionals, I graduated from college with big dreams, a lot of ambition, and five figures of student loan debt.

I wondered if I could save money by refinancing this debt and reducing my interest rates, so I decided to explore my options.

First, I contacted a few dedicated student loan refinancing companies. But the quoted rates were only about a percentage point better than the one on my government loans, and I didn’t think the savings were worth the loss of my government loans’ flexibility, like the ability to defer payments and change payment plans. This made me look elsewhere for other refinancing strategies.

While at a free “Credit Scores 101” presentation at my credit union, I learned about another refinancing option that might help me dramatically reduce my student loan rates… using my car.

Here’s what I found out.

What is a Car Equity Loan?

There are two types of car loans. The first, which most of us are likely more familiar with, is taking out a loan to acquire a car.

The second, which I discuss in this post, is an option if you already own a vehicle with positive equity -- the car is worth more than the outstanding debt on it. If this is the case, you are able to take out a loan equal to that equity.

For example, if you own a car worth $10,000, but you have an outstanding loan on it for $4,000, then you have positive equity of $6,000. Thus, you can take out a car equity loan up to $6,000.

You can use this loan for any purpose, including refinancing your student loans -- essentially switching from a higher interest debt to a lower interest debt.

The Pros of Car Equity Loans

Now the moment you have been waiting for: What are the benefits of this strategy?

Car loans can have a significantly lower interest rate than student loans, especially if you have good credit. Someone with good credit can get a car equity loan in the 3-5% range, according to Karen Bauer, Executive Vice President of 360 Federal Credit Union in Connecticut, which is where I received my loan.

I was offered a $20,000 car equity loan with an interest rate of 2.49%, based on the appraised value of my 2015 Chrysler and my good credit, to refinance my student loan debt. That interest rate is significantly less than the 6.5% rate on my government loan, and refinancing in this way will save me more than $5,000 in interest.

I will also pay off the car equity loan in six years -- three years sooner than I would have paid off the government student loan.

To me, that $5,000 in savings and shortened repayment term were worth the loss of certain government loan benefits, which I’ll discuss in the next section.

Your results will vary depending on your circumstances, such as your credit score and your car’s value. The better your credit score, the lower your rates will be. Your monthly payments will depend on your financial institution’s terms and interest rate. For instance, my credit union provided a term of repayment of up to six years.   

The Cons of Car Equity Loans

However, getting a car equity loan does come with some risks.

Financial institutions set interest rates based on perceived level of risk, explained Bauer. Unsecured loans, like many student loans, don’t have any asset tied to them, so they’re generally considered riskier for the institution. That means they often get higher interest rates.

Car equity loans have a lower interest rate, Bauer said, because your car acts as collateral. That means if you don’t pay back your loan, the financial institution has the right to take your car!

Refinancing your government student loan also means you lose the protections and flexibility they afford you, such as debt forgiveness programs and repayment plans that develop monthly bills based on time, income, and other factors. With a government loan, you may qualify for loan deferment, a temporary time where you don’t have to make payments for principal and interest, or forbearance, where you can don’t have to make payments but interest still accrues.

If you refinance with a car equity loan, you’ll lose access to these benefits. Unlike a government student loan, you probably could not postpone car payments for very long!

Another consideration: If the car depreciates faster than you can repay the debt, Bauer noted, you could end up owing more than it’s actually worth.

Finally, if the payment terms on your car equity loan are shorter than those on your student loan, you may have higher monthly payments. For example, I pay about $315 a month for the car equity loan, compared to the $260 a month I used to pay toward my student loan before refinancing.

Is Refinancing With a Car Equity Loan Right for You?

So is this the right option for you? That depends on your circumstances.

First, I would suggest comparing your credit score to Experian's ratings. While these ratings can vary depending on which credit model your financial institution uses and its internal classifications, Experian calls FICO scores of 800-850 exceptional, 740-799 very good, 670-739 good, 580-669 fair and 300-579 very poor.

Having a credit score on the higher end would likely increase your chance of receiving a low-interest car equity loan. However, if your credit score is in the lower range, you may not receive an interest rate that makes taking a car equity loan more attractive than your student loans.  

Second, only pursue this strategy if you have enough car equity to significantly reduce your student loan debt. Do you own your car outright or have a low remaining balance on a loan? Did your family give you a car? If so, you may have a lot of equity to tap.

If you’re not sure, ask the bank or credit union how they would value your car. Bauer explained that 360 Federal Credit Union, where I received my car equity loan, determined the value of my 2015 Chrysler by using data from the National Automobile Dealer Association (NADA). I checked the Kelley Blue Book and it showed a similar appraisal.

Finally, ensure you’re ready to be highly disciplined and can make the payments faithfully.

Other Tips for Getting a Car Equity Loan

Only apply for a car equity loan through a reputable financial institution, like a bank or credit union. Do not go to a sketchy loan shark who might use deceptive advertising and charge higher rates.

Shop around at a few different banks or credit unions to see who will offer you the best rates and terms.

Finally, Bauer recommended avoiding hidden fees and prepayment penalties. She also suggested getting guaranteed asset protection, which is coverage in the event something happens to your car (like an accident) that creates shortfall between what you owe and what your car is worth.

Your Turn: Have you used a car equity loan to help you refinance your student loans? Tell us about your experience!

Luis Valdez-Jimenez, J.D., M.B.A., is a legal and business professional in the aerospace/defense industry with extensive experience in compliance, auditing, negotiations and contracts. He is active in various community organizations that promote financial literacy, like the United Way, and briefly served on the Board of Finance of a town in Connecticut.