Paying Off a Car Loan Early: Pros and Cons
If you find yourself with excess funds, you may wonder if paying off your car loan early is good use of that cash. Having debt can be stressful, and car loans are probably the second largest debt most people carry.
Click here to find the best ways to pay off your current car debt.
So when does paying off a car loan early make sense? What are the benefits and the drawbacks? While it might be tempting to jump in and reduce your car debt, consider a few important factors first.
When Is Paying Off a Car Loan a Good Idea?
There are a few things to consider when deciding whether to pay down your car loan or put your extra money toward something else. Paying off your auto loan sooner is a good idea if:
You don’t have a lot of high interest debt, such as credit card debt.You need to lower your debt-to-income (DTI) ratio for a large purchase, such as a new home.Your auto loan interest rate is high.You have already built a solid emergency fund.You have negative equity on your vehicle because of a low down payment or high interest rate.Reducing debt is crucial to your current and future financial plans.
Pros of Paying Off Your Car Loan Early
Many benefits can come from paying your auto loan down faster or altogether. The pros of paying off your car loan early include:
You Will Save on Interest
One of the main benefits of paying off your auto loan early is saving money on interest. Interest for your auto loan gets spread out over the length of your loan. Because the interest amount for each month is calculated based on the loan principal balance, you will pay the most interest early in the loan’s life span.
Paying off your car loan earlier in the term will save you the most interest, but paying it off at any point can save you a lot. If your car loan has a high interest rate, the savings from paying off your loan early will be even more significant.
You Reduce Your Risk of Negative Equity
Cars can depreciate quickly, especially if you drive many miles each year. Some dealers will even offer car loans with no money down, which can further reduce the equity you have in your vehicle. High interest rate loans and low equity can cause you to become upside down quickly and owe more than your car is worth. This can be especially problematic if you end up totaling your vehicle and don’t have gap insurance.
If you can’t pay your entire car loan at once, calculate how much you must pay toward the principal to have positive equity in your vehicle. This is a good starting point for paying down your loan and protecting your money.
You Will Own Your Vehicle Sooner
For many people, their car is one of their largest assets. Yet, if you have a loan on your vehicle, you do not technically own it until you pay back the loan in full. The bank will either possess the title or be listed as the lien holder. You won’t be able to sell or trade in your vehicle unless you satisfy the loan during the process or before.
You Can Save on Insurance
When you have a car loan on your vehicle, your insurance must be enough to cover the value of replacing your vehicle if it were totaled. You might also be paying for gap insurance if you put no money down on your car or are a high-mileage driver.
Once you own your vehicle, you also have the option to eliminate collision coverage, which in some states can be a hefty portion of your insurance premium.
You Will Have a Better Debt-to-Income Ratio
Your debt-to-income ratio is something lenders weigh heavily when deciding whether to approve a loan. When borrowing money for a home mortgage, your DTI ratio can determine how much you can borrow, which can be crucial when house-hunting.
Paying off your car loan early will eliminate it from your debt-to-income equation, causing the ratio to improve and increasing your chances of qualifying for a better loan.
You Will Have More Money for Monthly Bills
If you choose to pay off your car loan early in one lump sum, it will free up funds for your monthly bills. You can take the monthly payments you were putting toward your car and use them to pay down other high-interest debt or put into savings. This can relieve the strain on your monthly budget or allow you to make progress toward other financial goals.
You Will Be One Step Closer to Being Debt-Free
Being debt-free is a financial goal almost everyone shares. Eliminating your car loan will decrease your overall debt and grow your assets. After tackling your car loan, you can use the money you saved on interest to help further reduce your debt until you are completely debt-free.
Disadvantages of Paying Off A Car Loan Early
While paying off your car loan early comes with many benefits, some drawbacks require careful consideration before you make a decision. Things to keep in mind include:
You May Be Subject to Prepayment Penalties
Some lenders include prepayment penalties in their loan contracts. These penalties are often in effect for a certain number of months or years and are designed to ensure the lender makes a minimum amount of money on the loan.
Often, a prepayment penalty will be a percentage of the loan’s balance. If you want to save money, read your contract carefully, and calculate your prepayment penalty amount if there is one. Then calculate the amount of money you will save on interest if you pay off the loan early. If the amount you save on interest is higher, paying the penalty might be worth it. If not, continue paying off your loan.
Your Credit Report Might Take a Small Hit
When you pay off your car loan early, your debt will become smaller. This is positive for your credit history but might lower your credit score slightly because you’re no longer logging on-time monthly loan payments. Once you pay off the loan, you will no longer have positive payment history for that long-term loan. This can affect your credit history mix, which credit bureaus like to see.
This slight dip in your credit score will only affect your credit history temporarily. Still, if you have a low score or need to maintain your score for an upcoming credit inquiry, it might be better to wait. Because credit mix is vital to getting a loan, knowing how each option affects it is essential.
You Have a Low or Zero Annual Percentage Rate
If the interest on your car loan is very low or you got a special zero percent interest rate, paying it off early offers little advantage. This is especially true if the interest rate on your car loan is less than you could make investing the money. In this case, it would be better to put your extra cash into investments where it will make more than the interest you save.
You Have Better Uses for Your Money
Even though it can be tempting to pay off your car loan early, ask yourself where your money will be best used. If you have high-interest credit card balances, a personal loan, a student loan, or other short-term debt payments with higher interest, you might benefit from using the money to pay the remaining balance on those debts.
You also might want to consider if you would be better served putting the money into a health savings account or retirement fund. These options also come with tax benefits.
Your Budget Is Already Tight
If you plan to spend extra on the principal each month to pay off your loan early, make sure it fits with your budget. If paying the extra money makes money tight, it’s best to wait. Emergencies can come up when you least expect them, and if your monthly budget is tight, you might not be able to cover the costs.
Remember that paying off a car loan early is only a good idea if it doesn’t put you in a financial bind.
You Don’t Have an Emergency Fund
Emergency funds are a vital part of life. From home disasters to medical crises to sudden job losses, emergencies can cause significant financial strain. Build an emergency fund that covers at least three months of income in case the unexpected happens.
If you don’t have a sufficient emergency fund, build it up before spending the money on an early car loan payoff.
You Might Be Tempted to Get a New Car
If you know paying off a car loan early might tempt you to shop for a newer model, it might be best to keep paying for your existing one. Even though a new car usually has minimal maintenance and repair, it will likely come with a higher monthly car payment and insurance cost.
Ways You Can Pay Off Your Car Loan Early
If you decide paying off a car loan early is the best option for your situation, you can go about it a few ways. The method you choose largely depends on your current monthly budget or the amount of cash you have on hand. Ready to get started paying off your car loan? Consider the following:
Pay Your Loan in Full
If you have money saved up or a sudden influx of cash, consider paying off the loan in one large sum. Make sure you can part with that amount without affecting your financial situation. Next, request a 10-day payoff amount.
The 10-day payoff amount will include the principal balance plus the interest accrued through the 10 days. Send the payment as soon as you receive the payoff amount so the lender receives it on time. After they receive payment, you should get a release of the title, allowing you to take ownership of the car.
Make a Partial Lump Sum Payment
If your funds don’t provide you with enough to pay off a car loan early in full, you can still save on interest by making a large payment toward the principal. While this will not reduce your loan payments, it will shorten the loan term and decrease the interest amount.
When making this lump sum payment, indicate on your online payment or payment voucher that the amount is to go toward the principal and not additional car payments. If you can’t find a way to indicate it as a principal payment on your paperwork, call your loan company and tell them you would like to make a principal payment.
Add More to Your Regular Payment
Perhaps large loan payments aren’t something you are financially able or comfortable doing, but you still want to pay down your auto loans quicker. Look at your budget and see how much more per month you can comfortably add to your payment without causing financial strain. Spending $100 more each month over a five-year loan of $25,000 can save up to 7 percent in interest payments on average.
If you can only pay a little more each month, try rounding up your payment. If your car payment is $375, consider raising it to $400. The $25 won’t strain your budget as much, and an even amount is easier when budgeting.
Increase Your Payment Frequency
You can pay your car loan faster by increasing the frequency of your payments. Instead of a monthly payment, see if your budget will allow for biweekly payments. You will be paying twice your monthly payment and can pay off your loan in half the time.
If you can’t swing the payment amount every two weeks, consider smaller biweekly payments that still total more than one monthly payment when combined.
Refinance Your Auto Loans
Refinancing your current loan can help you pay off your car loan early and save interest payments in certain situations. If you have a high interest rate and your current credit history or credit report allows you to get a better rate, then refinancing might save you money and allow you to pay your debt down quicker.
You can also consider refinancing for a shorter term to pay off your car loan early. This will allow you to pay it off sooner and for less. Just be sure to check for fees associated with the refinancing to ensure you are not paying more overall.
Is it worth paying off a car loan early? Paying off a car loan early is appealing for many reasons. It can be a good option as long as it doesn’t cause financial strain or involve funds better spent elsewhere. Before deciding, weigh the pros and cons, consider other factors and debts, and determine which payoff option works best for you.
Finance & Insurance Editor
Elizabeth Rivelli is a freelance writer with more than three years of experience covering personal finance and insurance. She has extensive knowledge of various insurance lines, including car insurance and property insurance. Her byline has appeared in dozens of online finance publications, like The Balance, Investopedia, Reviews.com, Forbes, and Bankrate.
