Should you pay off your car loan early?

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The decision of whether or not to pay off a car loan early can depend on a number of factors, including your financial situation, 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 a good idea.

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

With each monthly payment you make, a portion goes to pay the interest that’s accrued since your last payment, and the rest goes toward paying down the principal balance of the loan. If you add money to your payment, though, 100 percent of that extra amount typically goes directly toward the principal, especially if you specify that intention when you make your payment.

Not only does the practice reduce the balance on which interest is calculated, but doing it regularly can have a compounding effect on your savings.

For example, let’s say you have a $15,000 loan, a five-year repayment term and a 4 percent interest rate. If you pay the balance as agreed with no additional payments, your monthly payment will be $276.25, and you’ll pay $1,574.87 in interest over the life of the loan.

But if you add an extra $100 to each monthly payment, you’d pay $1,121.73 in interest, giving you a savings of $453.14.

The more money you add to your payments and the higher your loan amount, the more you can save. Use an auto loan early payoff calculator to find out how much you can save in your situation.

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, and you’ll have more options if you plan to sell the vehicle or trade it in to a dealer in the future.

Don’t owe more money than the car is worth

The vast majority of vehicles depreciate over time, and sometimes the depreciation occurs faster than the normal payoff schedule on an auto loan. This is especially true if you have a long repayment term or a high interest rate.

If you do end up owing more than your car is worth, 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.

Improve your debt-to-income ratio

Your debt-to-income ratio, DTI for short, is an important factor lenders use in the loan underwriting process. The figure represents the percentage of your gross monthly income that goes toward debt payments, and paying off your car early eliminates your auto loan from the equation.

If you plan to apply for other loans, lenders use your DTI to determine how much you can afford to borrow; so if you want to maximize, say, how much home you can buy, paying off your car loan can make a big difference.

Reduce your car insurance costs

Because auto lenders own the vehicle until you pay off the loan, they typically require you to pay for collision and comprehensive car insurance to protect their investment.

Once you own the vehicle outright, though, you get to choose whether to continue that coverage. Of course, it’s a good idea to keep the protection if you can’t afford to replace your vehicle in the event of an accident, but you may be able to adjust your levels of coverage as needed.

Free up money for other expenses

The average monthly payment on a new car is $563, according to Experian, which presents a significant opportunity to make progress on other financial goals. Even if you bought used, the $397 average payment could still make a big difference in your budget.

If you’re wondering if it’s better to pay off your car loan early, think about how you might use that extra cash flow every month to build your emergency fund, save for a down payment or prepare for retirement. You can also opt to use some of the cash for other expenses to boost your lifestyle.

Disadvantages of paying off a car loan early

While there are several pros to accelerating your auto loan payments, there are also some potential downsides to keep in mind.

Pay prepayment penalties

In some cases, lenders may charge a penalty for paying off a car loan early. You can find out if your lender charges such a penalty by checking the vehicle contract you signed at the dealership or the paperwork the lender sent you when it set up your loan.

If you find that the lender does charge such a penalty, compare the cost to the potential savings you might get from accelerating your payoff schedule. If it’s too expensive, you may consider refinancing the auto loan with another lender that doesn’t charge the fee.

Credit score may dip

The idea of an early debt payoff hurting your credit sounds like an oxymoron. After all, you’re managing credit well, right? However, 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).

The good news is that this dip is usually small and temporary, and as long as you continue to manage your credit accounts responsibly, it shouldn’t be an issue.

Could use funds for high-interest debt

Paying off any kind of debt can bring benefits, but if you have higher-interest debt, you may be better off focusing your efforts on those loans or credit cards instead. That’s especially the case with credit cards, certain personal loans and short-term debt.

By eliminating debts with higher interest rates, you’ll end up saving more money on interest charges. Plus, it can give you even more cash flow to put toward your auto loan once you’re ready to pay it off early.

Could use the money elsewhere

Paying off a car loan can be beneficial for your finances, but 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.

It also makes sense to avoid paying off low-interest debt quickly if you don’t have a robust emergency fund. After all, if you lose your job or experience a large unexpected expense, you can’t ask the lender to give back all your extra payments.

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.

How can I pay off my 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 or a tax refund, or you’re simply thinking about using money you’ve saved up over time, you may be able to make one lump-sum payment to pay off your car loan in full.

To do this, you’ll need to 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 how long you’ll be in debt.

Increase your monthly payment

If you don’t have a large amount of cash you can put toward your auto loan, you may 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.

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 make the right decision for you:

  • 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.

The bottom line

There are a lot of different factors to consider when deciding if you should pay off a car loan early. The most important ones to keep in mind are your financial situation, monthly goals and the cost of the debt. Take your time to research your options to determine the best strategy for you.

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