Should You Pay Off a Car Loan Early?
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Paying off your car loan early might save you money by reducing the total loan interest you pay. But if you have other higher-interest debt or no emergency savings, the disadvantages of paying off your car loan early could outweigh the advantages.
Many borrowers will qualify for student loan forgiveness, or will have some extra cash because of the extended student loan payment pause. Others might consider it after receiving a tax refund or other windfall. Whatever your reason may be, ask yourself whether the extra money you put toward paying off your car loan early could provide a more significant financial benefit elsewhere. Here are some pros and cons to consider.
Advantages of paying off your car loan early
Save on the interest you pay
The interest you pay on an auto loan is spread over the loan term. Part of your monthly car payment goes toward paying principal, the lump sum you borrowed, and part to paying the loan’s interest.
Most auto loans use simple interest, so the interest amount you pay monthly is based on the principal amount you still owe. Therefore, when you pay more than your required monthly auto loan payment, you’ll want to ensure the extra funds go toward paying the car loan principal. Doing this reduces the interest you owe and shortens your loan term.
For example, if you took out a $30,000 auto loan with a 6% interest rate and 60-month term, your monthly payment would be $579.98 and the total interest you pay would be nearly $4,800. However, if you paid an extra $100 a month for the life of the loan, you would pay it off in 50 months and save around $800 in interest.
Of course, it’s unlikely that most people will pay extra monthly throughout the loan term, but paying extra toward the principal now and then can still save you money. You can use NerdWallet’s auto loan extra payments calculator to see how paying more could reduce your auto loan interest and term.
Before assuming you’ll save on interest by paying your auto loan early, make sure your loan uses simple interest. A few lenders use precomputed interest, which means interest is calculated upfront and the amount remains the same each month. With precomputed interest, you could still owe the total interest even if you pay off your car loan early. This could mean paying off the loan early won’t save you money in the long run.
Lower your debt-to-income ratio
Your debt-to-income ratio, or DTI, is the total of your monthly debt payments divided by your gross monthly income. Lenders use this ratio to determine if your current income is sufficient to cover debt payments and living expenses.
Lenders consider your DTI when approving loans and determining how much you qualify to borrow. Eliminating your car payment from the DTI equation can help you secure future loans at a lower rate.
Avoid owing more than your car is worth
Paying your car loan off early reduces the risk of being upside down on a car loan. If you have a long loan term and your car depreciates in value during that time, you can end up owing more than the car is worth. Selling your car or totaling it in an accident could result in you having to pay the difference between your loan’s remaining balance and the car’s value.
In today’s market of high-priced used cars and dealer markups, being upside down in the near future isn’t likely. But if you paid much more than the sticker price for a car and took out a long-term loan, you could still become upside down if car prices start to drop.
Own your car sooner
Until you pay off your car loan, the lender technically owns the car and keeps the title. Therefore, the sooner you pay off your car loan, the faster you will have full ownership with the title in your name. Also, if you decide to sell or trade in your car, the process can be easier if you own it.
Disadvantages of paying off your car loan early
Owing a prepayment penalty
Prepayment penalties aren’t as common as they used to be, but some lenders still charge a fee if you pay off a car loan early. Review your loan agreement to see if a prepayment penalty applies. If it does, determine whether the amount you will save in interest is greater than your cost of paying off the car loan sooner.
Preventing better use of your money
Before paying off your auto loan early, consider how doing so fits your financial picture.
Will putting extra money toward your auto loan prevent you from paying off more costly debt first? Credit cards tend to have higher interest rates than auto loans and adjustable rates that can rise. Most auto loans have a fixed interest rate, so paying off credit cards or other high-interest debt may benefit you more.
Will paying more on your auto loan cause cash-flow problems, such as the inability to cover unexpected home repairs? If you don’t already have an emergency fund to cover unplanned expenses, it’s a good idea to direct your extra dollars there first.
And while discussing savings, consider long-term savings such as retirement funds. For example, suppose you have a very low interest rate on your auto loan (e.g., less than 10%). In that case, there may be a greater benefit in directing any extra money to retirement savings with a higher interest rate and tax advantages.
Lowering your credit score
Some borrowers believe paying off their car loan will boost their credit score, but that isn’t always the case. Many factors contribute to your credit score, including a history of payments and your mix of credit, such as loans and lines of credit.
Paying off your auto loan early eliminates the auto loan from your mix of credit accounts, which can cause a slight decrease in your credit score. However, any dip in your credit score should be temporary, as long as you don’t have other negative factors affecting it.
How to pay off a car loan early
If you decide that accelerating the payoff of your auto loan is a good idea for you, there are several approaches you can take.
Make a lump sum payment
If you happen to receive a large amount of money, you could pay the full balance of your auto loan. Don’t rely on the balance you see on a statement or online account. Instead, ask your lender for the loan payoff amount, which includes your remaining balance plus interest and any outstanding fees, for the date you plan to make the payment.
You could also make a lump sum payment for part of your balance. Talk to your lender to ensure the complete payment goes toward principal, so you receive the full benefit of paying off your loan faster.
Make biweekly payments
Some lenders allow you to make biweekly auto loan payments. To do this, you would pay half of your auto loan payment every two weeks. The result is 13 payments made in a year instead of 12, accelerating your payoff schedule and reducing interest paid.
Check with your lender first since not all lenders accept biweekly payments. Also, many are not able to accept biweekly payments through autopay.
Pay extra on your monthly car payment
If you can’t pay extra monthly, make a greater-than-minimum payment during the months you can. For example, if your minimum car payment is $634, add $50 to pay $684 or simply round up to $700. Ensure that anything you pay above the minimum amount goes toward your loan principal.
Again, check with your lender to ensure it accepts greater-than-minimum payments. Also, ask how the extra amount is applied to your loan. Some lenders apply the excess to the principal automatically. Others require you to designate that payment overage goes to the principal, for example, by including a note with your payment.
Another way to save on interest without paying off your car loan
Refinancing your car is another option if you simply want to reduce the interest on your auto loan without paying it off early. You may be able to refinance to a lower loan rate if your credit has improved or car loan rates have dropped since you took out your original loan. But be aware that refinancing to a longer term could increase the total interest you end up paying.
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