Should You Pay Off Your Car Loan Early?

Paying off your car loan before the end of the loan term can be a great idea, especially when you want to reduce your monthly debt payment faster. However, making this decision depends on several factors, such as your present interest rate, monthly payment, and whether you can afford to pay the final lump sum.

There are many reasons to pay off an auto loan early, such as to have more money in your pocket every month, but it’s not the best move for every car owner. Therefore, you will need to consider some advantages and disadvantages before paying off your car loan ahead of schedule.

Benefits of paying off a car loan early

Paying off a car loan ahead of schedule can have some significant benefits. Here are five key perks of paying off a car loan early.

1. Save money on interest

One of the biggest perks of paying off a car loan ahead of schedule is that it can save you money on the interest you pay. However, remember that this only applies if you are paying a simple and un-precomputed interest rate.

Simple interest is calculated monthly depending on what you still owe. This means if you pay off your loan earlier, you won’t have to pay the interest that you could have accumulated over the remainder of your loan. With precomputed interest, the lender determines the amount you would pay during the loan term and adds that to the principal loan amount. This means you are still likely to be at the helm for that amount whether you pay off the loan early or not.

2. Free up funds for other expenses

Paying off your car loan before the end of the loan term gives you a better chance to fulfill other financial goals and needs. When you no longer have to pay a loan, you will have extra money each month, which you can put toward retirement funds, vacation savings, and other debt or necessities. Imagine saving several hundred dollars each month!

3. Reduce the risk of being upside down on the loan

Car owners with long-term auto loans are at risk of owing more on their vehicle than it’s worth, a situation known as being upside down on a car loan. Although most lenders will allow rolling the amount into your new loan if you trade in your car, you may need to pay your lender the discrepancy in a round figure. The best way to avoid negative equity on your car is to pay off your auto loan early, reducing your loan term.

4. Enjoy full car ownership

Your lender technically owns your car until you pay off your auto loan. Therefore, the earlier you pay off your car loan, the sooner you fully own the vehicle. Getting ownership of the car means you will have the title in your name. It also means you will have more options if you plan to trade in or sell your vehicle.

5. Lower debt-to-income ratio (DTI)

Your debt-to-income ratio compares the money you owe each month and how much you earn. Generally, it’s the percentage of your gross monthly income (before taxes) that goes toward payment for mortgage, rent, credit cards, and other debts.

It’s always best to lower your debt-to-income ratio. The lower your DIT ratio, the easier it’s to get approved for a new loan, house mortgage, or credit card, and vice versa. Paying off your auto loan ahead of schedule gives you a lower DIT ratio, and you could boost your trustworthiness in the eyes of banks, credit unions, or other lenders.

Drawbacks of paying off a car loan early

While there are benefits to rushing your auto loan payment, there are also some potential drawbacks to consider. Here are a few disadvantages of paying off a car loan early.

1. Early payment penalties

Although prepayment penalties are not very common, some lenders charge a fee if you pay off your car loan early or even make extra payments. Be sure to review the terms of your car loan carefully to see whether prepayment penalties apply. If your current car loan comes with an exorbitant prepayment penalty, it might be better to pay off your auto loan on its regular schedule and put the extra money towards something else.

2. Lower credit score

It’s helpful to keep up with a car loan to prove that you are reliable at paying off debt, especially if you are still trying to build your credit history. However, if you stop making payments on a loan because you have paid it off, it reduces your total credit mix and open accounts, which can cause a dip in your credit score.

Don’t be discouraged, though. This drop is usually small and temporary, and it shouldn’t be a problem if you continue to manage your credit accounts responsibly.

3. Budget strains

Using up your savings or making bigger monthly payments than you can afford might help you pay off your car loan faster, but it could make it difficult to cover emergency expenses later. Before you decide to pay off your auto loan ahead of schedule, take the time to examine your budget and make sure it won’t put you in a dangerous situation.

How to pay off your car loan early

There are a few options when it comes to repaying a car loan. You can pay an extra amount each month in addition to your regular monthly payments or make several or one big lump sum payment. Refinancing can also help you pay off your car loan faster if you are in a stronger financial situation than when you first bought the car or if your credit score has improved.

The bottom line

Provided your lender doesn’t charge a prepayment penalty and you don’t have other high-interest debt, paying off your car loan ahead of schedule can save you money. Even a few extra payments can help reduce the total loan interest you pay.

However, before you rush to repay your car loan, do the math to determine whether it makes financial sense or if you should spend extra money elsewhere. In addition, keep your financial goals and situation in mind as you consider the pros and cons to determine your best strategy.