Suppose you get a bonus at work or come into an unexpected windfall. You might be tempted to use that extra money to pay off your car loan early. Depending on your situation, you can benefit from paying off your loan, or you might experience some drawbacks. This guide will help you decide whether paying off your car loan early is a good option.
When Does It Make Sense To Pay Off Your Car Loan Early?
If any of the following circumstances apply to you, consider making an effort to eliminate your automotive loan debt:
- You don’t have any higher-interest debt. If you have credit card debt or loans with a higher interest rate than your automotive loan, it makes sense to pay off those debts first. However, if your automotive loan is your debt with the highest interest rates, it’s a good idea to pay your auto loan off early and free up some cash for other purposes.
- You want to invest in the stock market. Does your car loan have higher interest rates than what you could potentially earn by investing? If you pay your loan off early, you can free up cash to invest in the stock market or put in a high-yield savings account. That way, you’re earning interest instead of paying for it.
- You want to purchase a house in the near future. Paying off your car loan early will reduce your debt-to-income ratio, making you better qualified for a home loan.
- You recently came into some extra money. If you’ve recently experienced a financial windfall and already have plenty of money stashed away for emergencies, it makes sense to put the extra cash toward your auto loan.
- You want more financial security. Paying off your car loan early can bring you closer to greater financial security because you’ll have one less debt.
What Are the Benefits of Paying Off Your Car Loan Early?
Paying off your car loan early has several benefits, including:
Saving Money on Interest
When you pay your auto loan each month, you’re paying off part of the principal, which is the amount you borrowed, and you’re paying interest, which is the cost of borrowing. Depending on whether you have a simple-interest loan or a pre-computed interest loan, you could owe less interest if you pay your loan off early.
For example, if you took out a simple-interest loan for $25,000 with a 60-month repayment term and 5% interest rate, you’ll owe $28,206.85 if you take 60 months to pay it off. That’s for the $25,000 principal and another $3,306.85 in interest. If you pay the loan off in four years instead of five, you’ll only owe $2,635.15 in interest.
Remember, paying off your loan early only reduces the amount of interest if you have a simple-interest loan. If you have a pre-computed interest loan, the interest you owe is calculated upfront, and the amount of interest you owe is fixed. That means you have to pay the total amount of interest even if you pay the loan off early.
Avoiding an Upside-Down Loan
If you purchase a brand-new car, truck, or SUV, it starts to depreciate as soon as you drive it off the lot and can lose up to 20% of its value within one year of owning it. While depreciation slows after the first year, your vehicle might end up being worth less than you owe on it, especially if you have a long-term or high-interest loan.
An upside-down loan can cause problems if you want to trade in your vehicle or it’s totaled in an accident. You’ll typically have to pay off the difference or roll the amount into your new loan, which can result in unnecessarily high car payments. Paying off your loan early decreases the risk of an upside-down loan.
Taking Ownership of Your Vehicle Sooner
While you still owe money on your car, the lender is technically the owner. After you pay the entire loan off, you’ll receive the title in your name, and you’ll have more options if you ever want to sell the car privately or trade it into a dealership. You can also drop any additional insurance coverage your lender might have required you to purchase when you took out your loan.
Disadvantages of Paying Off Your Car Loan Early
Before paying off your car loan early, consider the following potential drawbacks:
- Prepayment penalties: Some lenders charge a penalty fee if you pay your loan off early or make extra payments. If your lender charges a penalty fee, compare it to the potential savings of paying the loan off early. If the cost outweighs the savings, you’re probably better off sticking to your lender’s payment schedule.
- Lower credit score: Once you pay off your car loan, it no longer shows up as a positive payment streak on your credit report, which could lower your score. However, this drop is typically small and temporary, and if you have other loans and credit accounts that you’re handling responsibly, you might not see a dip.
- Impact on your overall budget: Putting extra money toward your auto loan might stretch your budget and leave you unable to pay for other expenses. Before you commit additional funds to your car payment, ensure you can still cover your other financial commitments.
How To Pay Off Your Car Loan Early
If you’ve decided that the benefits outweigh the drawbacks of paying off your car loan early, here are a few options you can consider to pay it off ahead of schedule:
- Pay your loan off in full. Perhaps you’ve received a significant work bonus, tax refund, or another financial windfall that’s enough to pay your entire loan off. Contact your lender to find out your 10-day payoff amount, which includes any interest accrued since your last payment, then send your lender a payment for that amount.
- Pay a partial lump sum. If you don’t have enough money to pay off the entire loan, you can still pay down a huge portion with a lump-sum payment. With a simple-interest loan, you’ll reduce the amount of interest you have to pay by paying off a significant amount of the principal.
- Increase your monthly payment. Even if you don’t have a big chunk of money to put toward your loan, you can still save money on interest and pay the loan off a little early by paying extra each month.
Though it may depend on your situation, paying off your car loan early can help you lessen your financial stress and get closer to financial security.
At FIXD, our mission is to make car ownership as simple, easy, and affordable as possible. Our research team utilizes the latest automotive data and insights to create tools and resources that help drivers get peace of mind and save money over the life of their car.