Should You Pay Off Your Car Loan Early?

Paying off your car loan early could be a smart financial move. It could help you to save on interest and free up more cash for you to use each month. Likewise, paying off your car means that you’ll own it outright, which is an exciting prospect for many people.

However, there are a few downsides to paying off your car loan early: including fees and a potential dip in your credit score.

In this article, we’ll look at the pros and cons of paying off your car loan early. See whether it makes financial sense for your situation.

• You Could Save On Interest
  Paying off your car loan interest early could result in you paying less interest over time. That’s because a portion of your payment each month goes toward paying the amount that you borrowed, while part goes to paying interest on the loan. Keep in mind that the type of interest that your loan uses will impact how much money you’ll save by paying it off early.
  
  
  • Simple Interest
    If your loan uses simple interest, the amount of interest that you pay is based on the amount that you still owe. Paying off your loan early, in this case, can reduce the amount of interest that you end up paying over time as it shortens the duration of your loan.
    
    
  • Precomputed Interest
    Some auto loans use precomputed interest. With precomputed interest, interest is calculated upfront and added to your principal at the beginning of your loan. With this type of loan, you may still have to pay the precomputed interest even if you pay it off early.¹
    

When considering paying off your auto loan, you’ll also want to consider what other outstanding debts you have. If you have other debt with a higher interest rate than your car loan, then it could make sense to opt to pay off this debt first for greater savings over time.


• You’ll Avoid the Risk of Owing More Than Your Car Is Worth
  Another potential benefit of paying off your auto loan early could be that you reduce the risk of ending up with a loan that is greater than the value of your car. This could happen if you have a long-term loan and your car’s value depreciates in that time. Should you end up totaling your car or selling it, you may have to pay the difference between the loan’s remaining balance and your car’s value.
  
  
• You Will Own Your Car Outright
  As long as you’re still making payments on the loan, the lender will typically still own the car. Paying off your car loan early means that you’ll own the car free and clear.

Here are a few potential drawbacks to paying off a car loan early:

• Prepayment Penalties
  In some cases, borrowers are charged a fee for paying off a loan early because the lender will lose out on interest they would have earned from the loan. You can check if your contract has a prepayment penalty fee by reviewing your loan agreement.
  
  
• It Could Cause a Financial Shortfall
  Paying off your car loan could cause a financial shortfall if you’re using a significant portion of your savings to do it. This approach could leave you with less money in case of emergencies.
  
  
• It Could Cause Your Credit Score to Dip Slightly
  Paying off your car loan may lower your credit score slightly in the short term.² This is because it reduces your average account age and credit mix. Therefore, you may postpone your payoff if you need to maximize your credit score for a big purchase or open a new credit account.
  
  However, this drop is usually only temporary.³ Lenders prefer to see borrowers paying off installment loans, as it demonstrates good debt management skills more so than simply avoiding all debt.
  
  As long as you continue using credit responsibly and making on-time payments, your credit score could recover and keep increasing.

Here are a few reasons why it might make sense to pay your loan off early:

1. If the Loan Has a High Interest Rate
   Paying off a loan with a high interest could reduce your interest costs substantially. This could lead to greater financial security from month to month. Just make sure the loan doesn’t use precomputed interest, because this could mean that there may be less incentive to pay it off early.
   
   
2. If You’re Not Worried About a Slight Dip In Your Credit Score
   A slight, temporary dip in your credit score is not often something to worry about if you don’t need to get a new loan or credit card soon. Therefore, there may be little to no downside to paying off your loan early if you won’t need new credit for a while.
   
   
3. If You Need to Lower Your Debt-to-Income (DTI) Ratio
   Your DTI ratio measures your monthly debt payments against your monthly income. Mortgage lenders consider your DTI ratio when approving you for a mortgage. A lower DTI ratio is more favorable. Therefore, paying off the auto loan could help you if you need to reduce your DTI in order to obtain a mortgage. One strategy would be to pay your car loan off early if you’re planning to get a mortgage. That way, your credit score will have a chance to recover, and you can still benefit from having a lower DTI ratio.
   
   
4. If It’ll Free Up Capital Which You Can Then Invest Wisely
   Paying off a loan provides additional monthly cash flow and reduces interest costs. You could use these extra funds to invest wisely, potentially moving toward financial goals faster. Keep in mind, however, that this scenario only makes sense if your projected returns will potentially outweigh the interest savings that you’d have from paying off the car loan.
   
   
5. If There Are No Prepayment Penalties
   Some lenders charge prepayment penalties to make up for interest they could lose if you pay the loan off early. This could potentially outweigh any potential interest savings, especially if you’re nearing the end of your loan’s term and there’s not much interest left to pay. Be sure to carefully review your loan documents to see whether there are any prepayment penalties.