When you’re financing a car, you’re making bi-weekly or monthly payments for a fixed period. Should you choose to pay off your car loan early, you have that option, but there are certainly advantages and disadvantages to this that you need to consider. To answer this question simply, if you’re in a comfortable situation financially, and don’t have other active loans or outstanding debts, paying off your car loan would be a decent idea. However, if you are juggling multiple loans or have outstanding debt, you’re probably better off just making your car loan payments as initially outlined.
When is Paying Off Your Car Loan Early a Good Idea?
These are a few of the factors worth considering when looking at paying off your car loan early:
- You don’t have other high-interest debt/loans
- The car loan’s interest rate is higher than what you could be investing in
- You’re looking to get a mortgage and you want to lower your debt-to-income ratio
- You have enough money to live comfortably even if an emergency situation were to occur
- You typically don’t have debt, so you want to pay off all your outstanding debts
The Pros of Paying Off a Car Loan Early
1. Save Money on Interest
Unless you have 0% financing, you’ll be paying interest for the entirety of your loan term. Therefore, if you’re able to pay off your car loan before the loan term ends, you’ll be able to save money on interest. Even if you can’t pay off the car loan in full right away, making extra payments here and there until the loan is entirely paid off is smart.
2. You Get Ownership Sooner
This is self-explanatory as when you’re done paying a loan you take ownership of whatever the item the loan was intended for, but this has a deeper meaning. It means that the vehicle title will be in your name and you have the option to sell it privately or trade it in to a dealership. Your lender may have had a minimum insurance policy, so now that you’ve paid the loan you can opt for less coverage and a less expensive insurance premium.
3. Lower the Odds of Being in an Upside-Down Loan
Cars can depreciate quicker than the payoff schedule of the loan, putting the person borrowing in what’s known as an upside-down loan. This is more common with long-term loans with high-interest rates, and you should avoid being in an upside-down loan at all costs. It’s especially problematic if you intend to trade in, sell privately or if the car is totaled.
4. Improve Your Debt-To-Income Ratio
A debt-to-income ratio is the percentage of money that you put towards your outstanding loans compared to your total income. It’s a critical factor that lenders look at to determine the amount they’re comfortable lending you. The higher your DTI, the higher risk the lender will look at you as a borrower. If you’re able to pay off your car loan, your DTI will decrease as you no longer have recurring car loan payments.
5. Free Up Money
Chances are, you’re paying anywhere from, $300-$800 per month on a car loan. That’s a lot of money for anyone to fork up month after month, for years. If you’re able to pay off your loan before the term ends, you’re freeing up that fixed monthly payment amount. If you keep the car you have after paying off the loan, that extra money can go towards a vacation, a boat, or a savings account.
The Cons of Paying off a Car Loan Early
1. Money Could Be Spent Elsewhere
If you’re managing multiple loans at once and you’re considering paying one early, it makes sense to pay the one with the highest interest. Credit card debt especially should be taken care of before you consider paying out your car loan. Even if you don’t have other outstanding loans, perhaps you’d be better off putting that money towards a savings account or retirement fund.
2. Won’t Help to Improve Your Credit Anymore
As we’ve talked about in previous blogs, a car loan is one of the best ways to improve your credit score. As you consistently make your loan payments on time and in full, you will see your credit score increase. However, once you’ve fully paid off your loan, you will no longer be able to use the car loan to improve your credit. If you already have fantastic credit or have other open loans, this shouldn’t be a big deal at all. If this is your only open loan and you have mediocre credit, it may make improving your credit score difficult.
3. May Not Be Realistic With Your Budget
As nice as it would feel to pay off your car loan early, it may not be realistic for you. Even if you can cut back on other areas of your spending, finding extra money to put towards your car loan may not be a good idea. Don’t put yourself in a situation where you’re one emergency away from being in a financial crisis. It’s important that you do a thorough audit of your financial situation before you decide to pursue paying off your car loan early.
How to Pay Off Your Car Loan Early
Pay It Off In Full
If you happen to be in a situation where you have enough money to comfortably pay off your car loan in full, go for it. Maybe you got a bonus at work, inherited some money, won the lottery or have been diligently saving up, regardless, bringing that loan balance to $0 will feel great.
Make Partial Lump Sum Payments
If you don’t have enough money to make one payment to close out your loan, perhaps you can make multiple large payments over time to end the loan early. While this won’t reduce your monthly payments, it will significantly decrease the length of your loan term.