For people with outstanding car loans, the thought of an early payoff has probably crossed their minds. It would allow not only full ownership of their vehicle but also extra cash to put toward their monthly budget.
Whether it’s a good idea, though, is a question with a potentially complex answer. It depends on a variety of factors, including the kinds of debt you have, the interest rate of your car loan, and your current financial situation.
If you’re thinking of paying off your auto loan ahead of schedule, you want to consider these factors and others to ensure you’re making the right decision.
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Should You Pay Off Your Car Loan Early?
Paying off a car loan early isn’t the right choice for everyone. Determining whether you’re the right candidate begins with asking particular questions about your financial situation and preferences.
If you can answer yes to any or all of the following questions, you could be one such candidate:
Do You Lack Other High-Interest Debts?
If you don’t have other high-interest debts that are more expensive than your auto loan, it could make sense to clear away your auto loan. As a result, you’d have more money to put toward other pursuits, including personal savings and high-value purchases.
Generally, if you are paying more in interest than you can earn on savings and have adequate emergency cash, it is a good investment to pay off the high interest loan. If you are lucky and have a low or 0% loan, then think twice before repaying that loan early and instead build up your savings.
Do You Plan to Make a High-Value Purchase Soon?
If you’re planning to make a high-value purchase, such as a home, you’d do well to lower the amount of your debt relative to your income. Paying off the entirety of your auto loan would do just that.
Are You Looking to Avoid Being Upside Down?
Being upside down on your auto loan means you owe more on your loan balance than the vehicle is now worth.
For example, if your car has depreciated to a value of $15,000 but you still owe $16,000 on the loan, you’re upside down. If that’s something you wish to avoid, early payoff of your loan could be a smart move.
Do You Have Enough Reserve Cash?
Having sufficient reserve cash means you have enough money to cover your other expenses after paying off your auto loan.
Make sure you can answer in the affirmative before moving forward with the decision.
Are You Averse to Debt?
Being averse to debt means you don’t like owing money. While that’s only natural, managing debt wisely is how you build credit.
If the mere thought of owing a large sum of money to a lender causes inordinate levels of anxiety, however, you might consider getting out of that debt as soon as possible.
How to Pay off a Car Loan Early
You can pay off the balance of a car loan in one of three ways. One is to wipe it all out with a single lump sum. To do this, you’d either log in to your loan account online or contact your lender to determine how much you owe — the principal plus interest and fees.
Then you’d use your credit card or cut a check for the amount specified. If you’ve recently come into a windfall, you might want to consider this method.
The second method is to pay several large sums until you’ve covered the total of your balance. You might need to budget tightly while you’re making these large payments, but you’ll get out of your auto loan much faster.
The third method is to increase your monthly payment amount. You’d still be paying long-term, but you could decrease the life of the loan significantly. This option is suitable for those who can’t afford to put forward a lump sum or multiple large sums.
In all cases, make sure to follow-up with your lender and request your lender provide you proof that the loan has been satisfied. You don’t to pay off the loan only to find there is still a lien on the car when you go to sell it.
What Are the Advantages of Paying off Your Car Early?
If you’re still on the fence about paying off your car loan early, consider these benefits you could enjoy by taking the plunge:
Money Savings
Saving money is the primary reason to pay off a loan before its term expires. By paying off the balance faster, you give the lender less time to collect interest on the loan.
For example, imagine you’ve just taken out a car loan for $25,000 with a term of 72 months and an annual percentage rate of 7%. If you make no additional monthly payments, you can expect to pay $5,686 in interest aside from the $25,000 principal.
However, if you pay an additional $200 per month, shortening the loan term by more than 20 months, you could save almost $2,000 in interest payments.
This is only the case if you’re paying a simple interest rate. The way that works is the lender calculates interest based on the amount of your loan balance on the due date for a particular payment.
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If you’re paying a precomputed rate, the lender calculates a fixed rate at the very beginning of the loan contract. Even if you were to pay off your loan early, you could still owe the total amount of interest.
Lower Debt-to-Income Ratio
Debt-to-income ratio (DTI) is a measure of how much debt you pay every month relative to your income in the same period. It includes not only your loans but also expenses such as rent.
Expressed as a percentage, DTI is one of the factors lenders consider when they decide to approve or deny a loan. In their view, a lower DTI means less risk.
Paying off a large debt, such as your auto loan, lowers your DTI instantly by removing that sum from the calculation. Imagine your monthly income is $5,000, and your monthly debts amount to $2,400, resulting in a DTI of 48%. Almost half of your income is gone because of debt. If you were to remove, say, a $700 monthly auto loan payment, your DTI would drop to 34%.
Just like that, you’ve gone from a fairly lousy DTI to a good DTI. Consequently, you’re more likely to qualify for important loans, such as mortgages.
Staying Right Side Up
As mentioned, being upside down on your car loan means you owe more than the vehicle’s value. When that happens, you have negative equity, presenting challenges if you want to sell your vehicle, you’re looking to trade it in, or you total it in an accident.
In each of these cases, you’d only get enough money to cover a portion of your remaining balance. The rest of it would come out of your pocket and go into the lender’s.
If you can pay off the loan balance before it exceeds the vehicle’s value, you’ll manage to stay right side up. That’s a much better and more financially secure position to be in.
Full Vehicle Ownership
As long as you’re still paying off your loan, your lender essentially owns your vehicle. As soon as you pay off the loan, the vehicle is entirely yours. Having full ownership is about more than just pride and principles.
It can also confer further financial advantages. For example, a common stipulation of auto loans is minimum insurance coverage. When you no longer have to satisfy the loan requirements, you can switch to a more affordable coverage option, thereby saving even more money.
Extra Cash on Hand
Having paid off your car loan, you now have a chunk of money freed up for other expenses. Celebrate by treating yourself to something special, or put it toward one of your financial goals.
Alternatively, channel it into paying off another one of your loans more quickly and enjoy all these advantages twofold.
Disadvantages of Paying off Your Car Early
Before you decide to pay off your car loan early, know the direct and indirect disadvantages of doing so, including:
Prepayment Penalty
Generally speaking, lenders don’t want you to pay your loan off early. They want to keep collecting interest because that benefits them. Therefore, to discourage early payoff, some lenders charge a prepayment penalty.
The penalty amount varies depending on the lender and the conditions of the loan agreement. Look over your contract carefully, and decide whether the benefits of early payoff outweigh the financial impact of this charge.
Potential Credit Hit
Your credit profile relies on several factors. One is your payment history. During the time you were consistently making auto loan payments, you were building up your credit. When you pay it off, you no longer have that channel through which to bolster your credit score.
Total payoff of your auto loan also diminishes your credit mix, another factor behind your credit score. Credit bureaus generally like to see that you have both revolving credit and installment credit. Removing an installment credit account, such as your auto loan, might cause a dip in your score as well.
Fortunately, the impact on your credit from paying off your loan is likely temporary. As long as you continue to manage your credit and finances effectively, you should be able to regain anything lost in this regard.
Tighter Budgeting
Whether you opt to pay off your car loan balance in one lump sum or increase your monthly payments, the need to tighten your budget is a consequence you’ll likely have to deal with. If you’ve planned wisely, you should be able to manage your expenses with a small degree of sacrifice. If not, you might struggle to meet your needs.
To prevent this scenario, consider as many financial possibilities as possible before you decide to pay off your car loan. Should you find you might experience excessive financial hardship as a result of the payoff, consider delaying or forgoing the action.
Opportunity Cost
The term “opportunity cost” refers to any value or gain you forfeit by choosing one option over another. In this case, choosing to pay off the sum of your auto loan might result in an opportunity cost relating to your other debts.
For example, if you have credit card debt, you could’ve potentially gained more by paying that off first. This is especially true because credit cards tend to have higher interest rates than auto loans. Because you chose to pay off your car loan instead, you’ve lost some of the opportunity to benefit from wiping your credit slate clean.
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Finance Editor
Jim Slavik is a financial services expert with 30 years of strategic and operational experience including leading underwriting, loan administration, customer service and collections. He has held C-suite credit operations roles for Fortune 100 and private equity companies for credit cards, personal loans, lease-to-own, auto loans, mortgages, and insurance for prime and sub-prime borrowers.
Currently Mr. Slavik is an independent financial services consultant for private equity firms and a contributor for expert networks such as GLG, Guidepoint, and Level company amongst others.
