Should I Pay Off My Car Loan Early or Not?
“I want to pay off my car loan early.” Who doesn’t think that? Who doesn’t dream of a windfall that would free them from all debt or an income boost that would allow them to pay down a big chunk of what they owe with monthly payments?
If you are lucky enough to be able to reduce your debt burden, should you do so? Which debts should you pick off first? And where should auto loans fit in with your plans?
Reasons to avoid paying off a car loan early
It is generally a good idea to pay down debt whenever you can. But there are exceptions:
When you have better uses for the money
You can only spend each dollar you have once. And if you use funds for increased monthly payments or to pay off your auto loan completely, that money is gone.
But might you have better uses for it? Might you end up better off if you invest it? Is your emergency fund (the cash cushion that protects you from unexpected financial, medical, and employment disasters) as big as it should be?
When you have worse debts
Many debt advisers recommend paying down debts in order of the annual percentage rate (APR) you are being charged, starting with the highest. The sooner you get high-interest loans out the way, the sooner you will have more money each month to reduce your other balances.
Absent payday loans and the like, that generally means starting with your plastic. Most auto loans have modest APRs compared with store and credit cards so clear those first. This is especially important if your card balances (either individually or as a whole) are more than 30 percent of your credit limits. Take care of the balances that could really be hurting your credit score.
When you have a great deal
Some car loans have ultra-low or even zero-percent APRs. You might want to think twice before giving up such great bargains, regardless of your other debts.
Can you really think of nothing better to do with your money than paying down such an attractive loan?
When you need to borrow big soon
Your credit score will likely take a modest hit if you close old accounts. That is because your score is partly based on the average age of all your accounts and closing one will drag down that average. Your “credit mix” is also part of the calculation: Your score will be slightly higher if you have both “revolving” credit (open-ended accounts with minimum monthly payments that vary according to your balance, such as store and credit cards) and “non-revolving” credit (fixed-term, fixed monthly payment installment loans, such as mortgages, auto loans, and personal loans).
All this means paying a loan off completely could harm your credit score in two ways. You may be able to avoid this by paying down a big proportion of your balance, so reducing your monthly payments, without ridding yourself of the debt completely. Discuss your plans with one of your lender’s call center agents before doing this. Otherwise, you risk your lump sum being applied to your account incorrectly.
Closing an account will probably deliver only a small ding to your score, after which it should recover over a number of months. But even a few points off your score can make a big difference to the interest rate you are offered on a mortgage or other big loan. So never close (or open) an account when a significant application is on your horizon.
When the costs outweigh the benefits
You need to check your loan agreement. You are looking for two things:
- “Precomputed interest” – Some loan agreements (not all) contain this phrase. If yours does, it is important to understand what this means. Precomputed interest means your dealer or lender have ring-fenced the total interest you would have paid over the lifetime of your loan. And you are on the hook for all of it, no matter how early you pay off what you owe. That means there is literally no financial advantage in paying down early – unless you need to reduce your overall indebtedness for a particular reason (see debt-to-income ratio, below).
- Prepayment penalties – This is another way for dealers and lenders to deter you from paying down early. Again, these appear in only some loan agreements. You can still pay down early but you will have to pay a penalty if you do so. Just how much will depend on your agreement: some provide for relatively small penalties while others impose much bigger ones. You need to find out how big yours (if any) is and then calculate whether it makes an early payment uneconomic.
Is early payoff right for you?
Even if your APR is modest, you may still want to pay off your car loan early. Many people just hate having debt and make it their life’s work to keep it to a minimum. Here are some benefits of auto loan prepayment.
Have more financial security
Some will pay off their car loan early to create more financial stability. They like the feeling that a major employment or health event will have much less impact on their lives if they are not constantly struggling to keep on top of multiple monthly payments. Not to mention, they enjoy the fact they get to keep the money they earn instead of sending much of it straight back out to lenders.
What’s the price for peace of mind?
Many (maybe most) middle-class Americans pay tens or even hundreds of thousands of dollars in interest over their lifetimes. Some of that (a mortgage, perhaps, or student loans) may be inescapable.
However, much of it is elective: People choose to buy a better car or enjoy a fancier lifestyle than they can then afford, knowing they will pay their lenders for the privilege. While there’s nothing wrong with that, if you prefer to keep more of your own money, paying down debt early is a good way to make serious savings.
Avoid the opportunity costs of debt
Those with a smaller debt burden usually find it easier to save. And that is something most of us should do more.
Lacking cash reserves and other assets means you cannot take advantage of opportunities to make money. At the time of writing, stock indexes are close to their record highs. So, if you had had the savings to invest a few years ago, you might be richer today. Meanwhile, many a would-be entrepreneur has been stopped from getting a great business idea off the ground or investing in a successful start-up by having too big a personal debt burden. Debt comes with the cost of lost opportunities.
Reduce your debt-to-income ratio
Many are relaxed about those interest costs and opportunity costs. They see debt as a price worth paying for a lifestyle they value. And that is a valid choice. But even they may sometimes need to reduce their debt-to-income ratio.
This can happen when an application for a mortgage, home equity loan or home equity line of credit is on the horizon. Lenders will then crawl over your finances to see that you can afford payments on the new loan. And one of the things they will look at especially closely is your debt-to-income (DTI) ratio.
That is the proportion of your monthly income that goes back out again in monthly debt payments. And the lower yours is, the better your chances of your application being approved – and of being offered a lower mortgage rate, something that could save you serious money. Learn how to calculate your DTI ratio.
The refinancing option
Suppose you do not have the lump sum necessary to pay off your car loan early or reduce it. Or that you have decided that the opportunity costs of using that lump sum in that way are too high. You might still be able to lower your monthly payments (and so your DTI ratio) by refinancing your loan. If rates are currently lower or your credit score is now higher than when you applied for your existing auto loan, this is a real possibility.
And (absent pre-computed interest or prepayment penalties in your loan agreement), a refinance can help you to escape if you signed up for one of the horribly expensive deals that many dealerships routinely push their customers into signing. Next time, shop around for a great auto loan before you visit your dealer’s lot!
Alternatively, you might want to reduce the term (length) of your existing auto loan. That could increase your monthly payments, but mean you pay less interest in the end.
Deciding whether to pay off your car loan early is not as straightforward a decision as it first appears. Although paying down any debt is almost always a good move, there are times when your personal financial circumstances or the deal you signed mean it might not be.
Only you know the details of those circumstances and that deal. So weigh all your options carefully.