Paying off your car loan early: Should you do it?
Paying off your car loan early could come with benefits like reducing the amount of interest you pay and freeing up money for other expenses or savings — but there are also other factors to consider.
The thought of paying off your car loan early and doing away with your monthly payment is appealing. But should you do it?
Maybe you have a little extra cash each month, or you recently came into a large amount of money. Should you use those funds to pay off your car loan early? There are potential benefits, but also some possible drawbacks, to consider when deciding whether to pay off your auto loan ahead of schedule.
Benefits of paying off your car loan early
Paying back your lender early can be a good move for a number of reasons. Here are a few.
Save on interest
When you make your monthly payment on an auto loan, you’re paying both the principal, which is the amount you borrowed, and the interest and any fees, which is the cost of borrowing. Depending on the terms of your loan contract, you might pay less interest if you pay off your principal early.
For example, if you take out a $20,000 loan with a 60-month repayment term and 5% interest rate, you’ll end up paying $22,645 — the $20,000 original principal and then another $2,645 in interest. Paying off this loan early could save you on some of the $2,645 in interest payments — but it depends on whether you’re paying simple or precomputed interest on the loan.
If your car loan is a simple-interest loan, you pay interest based on what you owe at a given time. The sooner you pay off the loan, the less you’ll spend on interest — potentially saving you hundreds of dollars. If you paid off your $20,000 loan in four years instead of five, you would end up paying $2,108 in interest — a difference of $537.
But if you have precomputed interest, your interest is calculated upfront at the start of the loan and the amount of interest you pay is considered fixed. This means that if you pay off your car loan early, you could still be responsible for the full interest on the loan.
Free up funds for other expenses
If paying off your car loan early provides you with extra money each month, you could use some or all of that cash to pay down other debt, like your mortgage or student loan, or to build up an emergency fund.
Avoid owing more than your car is worth
According to a 2018 report by Experian, the average new car-loan term is now just under six years. If you have a long-term loan, there’s a chance that you’ll owe more on your car than it’s worth at some point in your loan term thanks to the car’s depreciation rate. When this happens, you have negative equity in your car — also referred to as being “upside down on your car loan.” Paying off your car loan early could help reduce that risk.
What to consider before paying off your car loan early
Even though it may seem like paying your car loan off early could be a great way to save money, it’s not necessarily right for every situation. Here are some things to consider.
Some car loans may come with a prepayment penalty, a fee that you’d be charged if you paid off your loan early. Be sure to read the terms of your car loan carefully. If your loan includes this fee, consider whether the financial benefits of paying off your car loan early outweigh the cost of this fee.
Think about any other debt you currently have, like credit cards and personal loans. If any of these debts have a higher annual percentage rate (APR) than your auto loan, it might make sense to pay down those balances first to save money in interest.
On-time bill payments can play a big role in determining your credit scores. Paying off and closing your car loan account may not hurt your credit, but keeping the account open could potentially have a bigger positive impact on your credit if you make payments on time and in full.
If your auto loan is your only account on your credit reports — or the oldest — it might be beneficial to keep it open as you continue to build your credit history.
It’s important to keep your other monthly expenses and your income in mind when you think about paying off your auto loan. If paying it off early would stretch your finances thin or leave you unable to afford other expenses that month, it might be best to stick with your current loan payment plan.
How to pay off your car loan early
Once you weigh out the benefits and drawbacks, you can decide whether it’s a good idea to pay off your car loan early. If you decide it makes sense for you, you’ve got a couple options for paying off your loan ahead of schedule.
One way to pay off your car loan early is to make one lump payment. Contact your lender to find out your car loan payoff amount and ask how to submit it. The payoff amount includes your loan balance and any interest or fees you owe.
You can also pay more than the minimum amount due each month. Making at least one extra payment on your loan every month, or adding more money to your monthly payment, may help you pay off your car loan early. But if you plan to go this route, ask your lender to specifically apply any extra payment to the loan’s principal.
While paying off your car loan early can be a wise move in many cases, you might find it just doesn’t make sense for your situation.
If paying early isn’t for you, don’t sweat it — there are other options, like refinancing your auto loan, that might save you some money. You could also establish or make changes to your budget so that paying off your car loan early is a possibility down the road.