The decision of whether to pay off a car loan early depends on your budget, your loan’s interest rate and your other financial goals.
In general, you should pay off your car loan early if you don’t have other high-interest debt or pressing expenses to worry about. However, if that money could be better spent elsewhere, paying off your car loan early may not be the best choice.
When does paying off a car loan early make sense?
There are a few scenarios where it might make sense to focus your efforts on eliminating your auto loan debt. Here are some qualifiers that can help you decide whether it makes sense for your finances:
- You don’t have higher-interest debt and want to free up the cash for other financial goals.
- The auto loan has a higher interest rate than what you could earn by investing.
- You’re hoping to buy a home soon and want to lower your DTI.
- You recently received a windfall and have enough cash in reserves for emergencies.
- You’re generally debt-averse, and it’s an important step for you in obtaining financial security.
Benefits of paying off a car loan early
If you can manage it, paying off a car loan in full ahead of schedule can have some big benefits.
Save money on interest
Since interest is typically spread out over the loan term, you’ll pay less interest when you pay off your loan early. But even an extra payment here and there can make a difference in savings. That extra amount should go directly toward the principal, especially if you specify that intention when you make your payment.
Use an auto loan early payoff calculator to find out how much you can save with additional monthly payments or one big lump payment toward your loan.
Key takeaway: The more money you add to your payments and the higher your loan amount, the more you can save.
Take ownership sooner
Until you pay off your car loan in full, your lender technically owns your vehicle. Taking ownership of the vehicle means that you’ll get the title in your name. It also means you will have more options if you plan to sell the vehicle or trade it in to a dealer.
If your lender required minimum insurance coverage, you could potentially reduce insurance costs by going for basic coverage. Owning the vehicle outright will put you in control of whether to continue insurance coverage or adjust levels. But it’s a good idea to keep the protection if you can’t afford to replace your vehicle in case of an accident.
Key takeaway: Owning your vehicle means it’s easier to sell and can potentially lower insurance costs.
Less risk of being upside-down
Sometimes cars depreciate faster than the payoff schedule of an auto loan. This is especially true if you have a long repayment term or a high interest rate.
Being upside-down on a loan, or owing more on the car than it’s worth, is a tricky situation. You may run into problems if you try to sell or trade in the vehicle or if the vehicle is totaled. In all instances, you may need to pay your lender the discrepancy in a lump sum — although most lenders will allow you to roll the amount into your new loan if you trade in the vehicle.
Key takeaway: Understand how your vehicle will depreciate and avoid owing more money on your loan than the value of the car.
Improve your debt-to-income ratio
Your debt-to-income ratio (DTI) is the percentage of your gross monthly income that goes toward debt payments. It’s an important factor lenders use to determine how much you can afford to borrow. The higher your DTI, the riskier you look as a borrower.
Paying off your car early eliminates your auto loan from the equation. Your DTI will naturally be lower, which opens you up for other forms of credit. It also helps improve your chances of refinancing other loans or consolidating credit card debt at a lower rate.
Key takeaway: A lower DTI ratio can help you qualify for better credit down the road.
Free up money for other expenses
The average monthly payment on a new car is $644, according to a report by Experian. Paying off your car loan early presents a significant opportunity to make progress on other financial goals. If you keep the car you have, and don’t take out another loan, you can put that money toward vacation savings, retirement funds or other debt. And even if you bought used, being done with the $488 average payment could still make a significant difference in your budget.
Key takeaway: Build extra room into your budget with several hundred dollars each month.
Disadvantages of paying off a car loan early
Prepayment penalties and less open accounts may impact your finances. So, while there are several pros to accelerating your auto loan payments, there are also some potential downsides to keep in mind.
Some lenders charge a penalty for paying off a car loan early or for making extra payments. Check your loan contract to see if your lender has one.
If your lender does charge a prepayment penalty, compare the cost to the potential savings you might get from accelerating your payoff schedule. If it’s too expensive, just continue paying down your loan on time — and put your extra money toward something else.
Lower credit score
If you stop making payments on a loan because you’ve paid it off, your streak of positive payment history will end. Additionally, your credit mix could be affected since credit bureaus like to see both installment loans, like auto loans, and credit lines, like credit cards.
Don’t let the fear of your credit score lowering hold you back from paying off your auto loan early, though. This potential dip is usually small and temporary, and if you continue to manage your credit accounts responsibly, it shouldn’t be an issue.
Money better spent elsewhere
If you have higher-interest debt, you may be better off focusing your efforts on those loans or credit cards first. That’s especially the case with credit cards, certain personal loans and short-term debt.
Even if you don’t have high-interest debt, that money could be used more effectively by putting it toward retirement, a Health Savings Account or some other tax-advantaged financial account. The same may go for general investing if your auto loan interest rate is low.
May not fit in your overall budget
If your budget is tight, it may be impossible to find any extra cash you can put toward your auto loan payment every month. Even if you can cut back in other areas, the focus may go back to other areas of your financial life that need more attention, such as high-interest debt, retirement and your emergency fund.
Before deciding to pay off your loan ahead of time, take the time to look at your budget and make sure it won’t place you in an even more precarious situation.
How to pay off a car loan early
Depending on how much money you have on hand, there are three ways you can work toward paying off your car loan ahead of schedule.
Pay it off in full
If you received a big bonus at work, a tax refund or you have money saved up, you may want to make one lump-sum payment to pay off your car loan in full. To do so, get the 10-day payoff amount, which includes interest that’s accrued since your last monthly payment. Then send a check to the lender or make the payment online to bring the balance to $0.
Pay it off in a partial lump sum
If you don’t quite have enough to pay off the balance in full, you may make a large payment to pay down a big chunk of it. This won’t reduce your monthly payment, but it can significantly cut down on how long you’ll be in debt. And since it will go toward the principal, you’ll wind up paying less interest overall.
Increase your monthly payment
If you don’t have a large amount of cash you can put toward your auto loan, consider making additional payments each month instead. You can decide how much extra you want to pay, and even a small amount can save you money and time.
The bottom line
Paying off a car loan early can save you money — provided there aren’t added fees and you don’t have other debt. Even a few extra payments can go a long way to reducing your costs. Keep your financial situation, monthly goals and the cost of the debt in mind and do your research to determine the best strategy for you.