Paying off your car loan faster can be a good option for you, but you need to know all the terms and conditions it involves. While you save on interest and significantly reduce your debt, certain disadvantages of paying off a car loan early, such as early prepayment penalties, if applicable, and loss of liquidity, can tag along.
Before you finalize the decision, you should weigh all the pros and cons. Let’s explore the subject in detail.
Can You Pay Off a Car Loan Early?
Yes, it is possible to pay off your auto loan before the term is over. The main deciding factors would be your financial situation and your lender's policy. If the lender allows it, you can pay off your car debt faster in the following ways:
One lump sum payment: You might be able to cover your remaining debt in a single payment if you get a better job, a work bonus, or a tax refund.
Additional monthly payments: Your loan is often divided into a set of payment installments. However, you can increase the amount on your own volition. For example, you add an extra $50 to each payment to reduce your loan term and the amount of interest you pay.
Biweekly payments: You can split the monthly payment into two and pay the auto debt every two weeks. While it seems like this wouldn’t have much impact, by the end of the year, you will have made one extra payment on your loan.
As you can see, it is not only possible to pay off your loan earlier, but there are a variety of ways to do so. However, there's an important factor to consider — your lender's policy. Sometimes, lenders include penalties for pre-term payments or add other conditions that will cost you extra. You should read those carefully before you proceed with any additional payments.
Paying Off a Car Loan Early: When is It a Good Idea?
There are a few common scenarios when you may want to start considering paying off your car loan early.
Pay Off Early When… | Do Not Pay Off Early When… |
You face high interest rates | You face low interest rates |
You have enough money | You don't have extra money |
You want to cut down on your monthly expenses | You have other high-interest debt payments |
There are no prepayment penalties | There are potential prepayment charges |
Benefits of Paying Off a Car Loan Early
One of the most obvious advantages of paying off your car loan early is saving money. In addition, if you close the loan for your vehicle faster, you can proceed with other goals, improve your credit history, and even out your debt-to-income ratio. Let’s explore how paying off your loan early saves on interest costs.
Saving on Interest Costs
You can save hundreds of dollars on interest if you choose to close your loan deal sooner. With most car loans, the interest is deducted from the remaining balance that you owe every day. That is why, if you make a few extra payments or initiate a lump-sum contribution, you will shorten the loan term and pay less interest.
A practical example may give you a better idea of what we are talking about. Imagine that you took a $20,000 loan for 5 years with 6% interest. The total interest over the defined period would be around $3,200. However, if you pay it a year sooner, you would save about $600 to $700.
Let's compare how much you can potentially save on interest, depending on the time span of your auto loan.
Term | Interest from regular payments | Interest and a 1-year early payout | Savings |
3 years | $1,900 | $1,500 | $400 |
5 years | $3,200 | $2,550 | $650 |
6 years | $3,900 | $3,100 | $800 |
These are estimated numbers, but as you can see, the longer the loan period, the more you can save on paying early. If you want to learn how much you would save, try our online loan calculators.
Freeing Up Your Monthly Budget
Early loan payoff also means that you will have extra cash at your disposal every month. For example, a $400 monthly payment is a substantial sum to contribute to other everyday needs. You can use this money as an emergency fund — in a year, you would have saved around $4,800. The same extra funds can go to your retirement account or be invested. Even the smallest sum will improve your financial flexibility, and that is a great benefit.
Avoiding Depreciation Risks and Negative Equity
These days, cars lose value pretty fast. This notion is called depreciation. So, if you still owe more than your vehicle is worth on the current market, you will end up in a so-called upside-down position (negative equity). In plain words, if anything happens, and you have to sell your car immediately, you won't make enough to cover the debt.
Paying off a car loan early is one of the best ways to prevent depreciation. Not to mention the fact that when you own the vehicle, you can focus on achieving other financial goals.
Lower Debt-to-Income Ratio and Improved Credit Profile
Once you eliminate monthly car payments, your debt-to-income ratio will improve. This is an important advantage because most lenders evaluate this ratio before approving the credit you seek. Moreover, the improvements will be reflected in your credit profile. Clients who appear reliable and trustworthy often receive better deals, lower interest rates, and rewards.
Disadvantages of Paying Off a Car Loan Early
Despite the numerous upsides of closing the deal sooner, doing so may not always be the ideal choice. There are scenarios when sticking to the initial loan term is the best course of action.
Prepayment Penalties
We've briefly touched on the penalties some lenders impose on clients who choose to pay off the loan early. To avoid prepayment penalties, you should always read the agreement carefully or ask the lender before you decide to proceed with making extra loan payments.
Budget Strain or Reduced Liquidity
You may be tempted to tighten your budget to an extreme to make additional loan payments. This choice, however, may place you in a financial corner. Emergencies don't come when you're expecting them, so always remember to balance your loan payments and your daily life needs.
Possible Impact on Credit Score
Your credit profile is a complex mix of factors, including your loans, credit score, credit history, and more. While a loan prepayment seems like a step up on your credit path, it can actually affect the credit score and credit history length in a negative way. How so? Well, your credit score depends on the credit mix — the variety of loans you have. Once you pay off your loan and have only credit card debt left, your mix will be one loan type shorter, which will lower your score.
The same goes for the history length, especially if you don't have that many active loans. On the bright side, the decrease will be temporary, as long as you maintain your other debt responsibly.
Weighing the Pros and Cons of Paying Off a Car Loan Early
We've discussed a fair share of the benefits and drawbacks of early loan payoff. However, it is essential to understand that not all of these will apply to your individual situation. Factors such as the loan's interest rate, remaining term, current cash flow, available savings, and personal goals can determine which pros and cons apply in your case.
When It Makes Sense to Pay Off Your Auto Loan Before the Term Is Over
Moving forward with the prepayment may be a good idea considering the following conditions:
Interest rates: The higher the interest rate, the sooner you may want to pay off the loan.
Sufficient funds: If you have an unexpected or expected income that seems enough to cover the remaining balance of the loan without putting your financial stability at risk, you may want to proceed with it.
Stable income: When you put your income and predictable expenses together, if it seems like there is enough cash left to increase the monthly payments, you can prepay your loan.
For instance, if you owe $10,000 at 8% interest and have $15,000 in savings, paying off your loan is a wise choice.
When It's Better to Continue Paying Regularly
There are cases when keeping the loan is a better solution:
You have a car loan with a low interest rate, like 2-3%. The interest cost in such instances is minimal, so it is not actually worth the effort.
You have better investment opportunities and can save money for those instead of paying off the loan.
You've read the lender's policy and found out that there are prepayment penalties outlined in your contract.
You want to maintain your liquidity and save cash for a rainy day.
Early payoff can be a powerful tool, but it's not always the best choice.
How to Pay Off Your Car Loan Faster
Most debts come with a fair share of psychological pressure weighing on you. It’s why many people seek ways to speed up the repayment process. There are a few proven strategies that can help you succeed with the task if your financial situation permits.
Lump-Sum Payment
A lump-sum installment is exactly what it sounds like — one big payment that makes the vehicle yours. As exciting as it seems, it often involves large sum contributions. It’s important to be sure that making a large payment won't affect the regular flow of your life. However, before rushing to write that big cheque, check your loan agreement for prepayment penalties or hidden fees.
Add Extra to Monthly Payments
Big bonuses and tax returns do not come on a daily basis, so not everyone can suddenly cover their loan in full. Yet, it does not mean that you can't close the deal sooner. Even a $50 monthly enhancement can shorten the loan term. For example, if your monthly payment is $350, increasing it to $400 might cut months off a multi-year loan and save hundreds in interest. This strategy works well for people with a steady monthly income.
Switch to Biweekly Payments
You can also pay off your loan faster by paying half of your monthly payment every two weeks. You may think that the math does not add up. However, if you look closely, you will discover that there are 26 biweekly periods in a year. They result in 13 full monthly payments instead of 12, which means that you will be at least a month ahead of your term each year.
Final Thoughts
Should you consider an early car loan payoff or let it go its course? It’s a question that does not have a one-for-all answer. Overall, dealing with the loan ahead of time may be a wise move. However, only if your financial health and the signed agreement allow it.
If you want to make the most informed decision, you may want to consult an expert on the matter. Contact us for the potential perks and downsides of paying off your loan.