If you've been paying off your car loan for a while now, you may be tempted to close the loan once and for all with one big payment.
But while paying off your car loan in full might seem like a great idea, it doesn't always work out to your advantage.
Keep reading to learn what happens when you pay off a car loan early and find out when paying off your loan is the right decision.
4 things to consider before paying off your car early
Here are four factors to consider before deciding to liquidate your auto loan ahead of schedule.
The first thing to review is your monthly budget. Obviously, you should only pay off your car loan early if you have the necessary funds to do so. If your other monthly payments suffer because you're putting extra cash toward your auto loan, you should reconsider.
Many lenders charge a penalty when you pay off your car loan early as a way to keep the profits they would have earned from interest if the loan had remained open.
Some lenders charge fees for early payments, while others only charge if you pay off your loan within the first six months or so. Check the details of your loan and do the math. If the costs outweigh the benefits, you're probably better off keeping the loan.
Your credit score
It might seem counterintuitive, but keeping your car loan open can actually help improve your credit score. That's because the length of your credit history counts for 15% of your score. The longer the duration of your loan, the more positive impact on your credit score.
Credit mix also counts for 10% of your score, so having a few different kinds of loans in your name can sometimes be a good idea.
To be clear, paying off your car loan shouldn't hurt your credit score too much. But if you've been making payments on time for several years and are in a position to continue to do so, it might be a good idea to keep it up and watch your credit score grow.
If you have any other outstanding debts — like personal loans or credit cards — you may be better off paying them first. To help you prioritize your debt payments, look at each loan's annual percentage rate (APR). The higher the APR, the more the debt costs, and the faster you should pay it off.
Advantages and disadvantages of paying off a car loan early
You may save money.
The longer your car loan's term, the more you end up paying in interest, so paying off your loan early can lead to considerable savings.
But this only applies if your lender doesn't charge a prepayment penalty, so check the details of your loan first.
It improves your debt-to-income ratio (DTI).
Lenders often compare your total debt amount to your total monthly income to determine your eligibility for a loan or credit card. Paying off your car loan lowers your DTI, making you a more attractive borrower.
It lets you own your car.
In addition to the pride of ownership, owning your car means your lender can't repossess it for late payments, and you pocket all the money from a potential sale.
Having equity in your car also means your car insurance premiums will most likely drop, saving you even more money.
Possibly requires paying penalties.
Again, some loan contracts include a fee for paying off your loan too early. If that's the case, it might cost you more to pay off your loan than to keep it.
Eats into your monthly budget.
Increasing your car loan payments (or closing your contract with a lump sum) requires more funds than making your regular monthly payments. If you don't have much wiggle room in your monthly budget, it may be best to keep that money for something else.
Potentially affects your credit score.
Although paying off your debt is always a good thing, in some cases, your credit score might temporarily drop after paying off your car loan. If your auto loan was the oldest loan in your credit history, paying it off shortens your borrowing history. It also reduces the diversity of your debt, which affects the credit mix factor of your credit score.
When to pay off your car loan early
Here are a few situations in which paying off your car loan faster is a good idea:
- You want to lower your DTI so you can apply for another loan, like a mortgage.
- You have extra cash and can afford to pay off your loan while keeping enough money in your emergency fund.
- You don't have any other debt with higher interest rates.
- Your auto loan costs more in interest than what you could earn by investing.
3 ways to pay off a car loan early
Pay it all with a lump-sum payment.
Your first option is to liquidate the remaining loan balance with one large payment.
Pay a little extra each month.
This can be a better option if you only have a limited amount of disposable income in your monthly budget to spare.
Make biweekly payments.
Making payments every two weeks instead of every month increases the number of payments you make per year and can reduce your total cost.
If paying off your car loan early isn't the right move for your current financial situation, other options exist, like refinancing your auto loan.
If your credit score has improved since you first got your loan, you may be able to refinance with better loan terms. And even if your credit score is the same, a different lender may still offer you better terms than your current one, especially if you initially financed with the dealership.
Interest calculations for a car loan
Many car loans calculate interest differently than other loans, like personal loans, mortgages, and credit cards.
While other loans often charge compound interest (meaning interest is charged on both the principal and accrued interest), many car loans charge simple interest, which is calculated based only on the loan's principal.
But while simple interest results in a lower interest charge over the life of the loan, lenders often find other ways to ensure a profit, like precomputed interest. With precomputed interest, lenders calculate the total interest on the whole term of the loan and include that amount in your contract. That means that even if you pay your loan off sooner, or make extra payments, the amount of total interest you pay does not change.
Car loans and early pay-offs FAQs
What is a pay-off car loan early calculator?
An auto loan early-payment calculator helps you know how much time and interest you can save by increasing your monthly car payments.
How does an auto loan calculator help with extra payments?
Auto loan calculators use the length of your loan term and interest rate to show you how much you can save by making extra monthly payments.
How do I find out my car loan amortization schedule with extra payments?
An auto loan early-payment calculator will show you how long your repayment term will be and how much you'll owe at a given period during the loan for both regular payments and accelerated payment plans.
Is it possible to pay off my loan early without a prepayment penalty?
Some lenders charge prepayment penalties, while others don't. Look at the details of your contract or contact your lender.
What happens if I pay extra?
Let’s say you voluntarily increase the amount of your monthly payment. Does that mean the lender applies it all to your next payment or use it to reduce your balance? Again, it depends on the details of your contract. If you want your extra payment to go toward your loan's principal, be sure to specify that with your lender.
Is it better to pay off my car or put money into savings?
In most cases, the interest rate on your auto loan will be higher than the average interest rate you'll earn from stocks or mutual funds. That means you're usually better off paying your debt first and investing later. But you may want to take a hybrid approach, depending on your financial situation.
The bottom line
Paying off your car loan can be a liberating experience. But sometimes, it's worth keeping that debt to make the most of all your financial opportunities.
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