Should You Pay Off Your Car Loan Early?

by Dori Zinn

Forbes Advisor

Friday July 16, 2021

Stock image
Stock image  (Source:Getty Images)

Paying off your car loan before the end of the loan term is enticing if you want to lower your monthly debt payments faster. But making that decision really depends on a few different factors like your current interest rate, monthly payment and if you can afford paying the final lump sum.

For most people, it might be worth it. But you'll want to assess your financial situation first before making the jump.


Benefits to Paying Off a Car Loan Early

If you have the funds to pay off your car loan early, it may reap some serious benefits.

1. Improve your DTI

Your debt-to-income (DTI) ratio is how much debt you owe compared to how much money you make. The lower your DTI, the better you look to future creditors and lenders, whether that's taking out a credit card or buying a home. Paying off your car loan will lower your DTI.

2. Save Money

Every car loan payment goes not only to the original borrowed amount — your principal — but also to your interest rate. Paying extra towards your principal lowers how much you'll pay in interest over the life of the loan.

Paying off your loan sooner means it will eventually free up your monthly cash for other expenses when the loan is paid off. It also lowers your car insurance payments, so you can use the savings to stash away for a rainy day, pay off other debt or invest.

3. Own the Car

Paying off your car loan early means you own the car free and clear, rather than the lender. If you ever need to turn around and sell it, you could earn more from that sale than you would if you still had a loan on it because the lender will expect payment first from the sale.

Also, taking out a car loan to pay for your car means that if you miss a payment or fall behind, the bank or lender can repossess your car. Even though you drive and maintain it, the car still belongs to someone else so long as there is a loan on it.


Downsides to Paying Car Loan Off Early

While there are some good things that come from paying off your car loan early, watch out for the downsides.

1. Prepayment Penalties

Some loan contracts come with prepayment penalties, which means that if you pay your loan off before the term is up, you could face a fee.

Keep in mind that many contracts are in place to avoid buyers paying their car loan off incredibly early, like six months after buying. If you pay yours off two years into your loan, for example, you might not face any fees. But you'll need to read over your car loan contract or contact your lender to see if this applies to your case.

If you do plan on paying off your car very early, compare the cost of the fee to the overall savings of paying off your loan well before the final date. If the fee is more than the savings, it might not be worth it.

2. Your Money Might Be Better Used Elsewhere

Paying off your car loan early frees up a good chunk of extra cash to keep in your pocket. But it's important to also look at how much you're paying monthly for other debts that might be costing you more. Which one has the highest interest rate? If your car loan's rate is low compared to other types of debt, like credit cards, consider paying off the debt with the highest interest rate first. That way you save more on total interest owed.

3. Credit Score Drop

Any time you pay off a debt, it lowers your total credit mix and open accounts, which can cause a dip in your credit score. But don't be discouraged. Most of the time, this drop is temporary and you should see a rebound within a few months. Lenders are more concerned that you manage your debts responsibly.


How to Pay Your Car Loan Off Early

Before completely paying off your car loan, review your options to see which one makes the most sense for your financial situation, like:

  • Pay off the full amount. In order to pay off the entire remaining balance, it may require a few hundred or thousands of dollars to be paid at once, depending on how much is left on your car loan balance.
  • Pay a partial payment. If you got a bonus at work or maybe sold something for a hefty chunk of change, you can use that money to make a large partial payment on your car loan.
  • Boost monthly payments. If you got a raise at work or a new side hustle, you can increase your monthly payments in increments. This will reduce the number of monthly payments you need to make to repay your car.


    When to Consider Paying Off a Car Loan

    This is a big financial decision and you should give it enough careful thought, just like you did when you first got the car loan. Consider paying off your car if:

  • You can afford it. If you don't have any other major, more expensive financial obligations, paying off your car loan makes sense. You'll free up money in your budget to put toward other things. But if you don't have the cash on hand, you may want to explore other options.
  • You don't have other outstanding debt. Look at your budget, including how much you bring in and what you're paying out. If you want to save on total interest, you may have other types of debt that's a bigger obligation. Credit cards or personal loans often have higher interest rates than car loans, which means you may want to direct extra financial resources there.
  • You're saving for a big purchase. A car purchase itself is a major financial decision, but if you're trying to save for a home, lowering your DTI ratio and boosting your cash on hand is a big deal. You can do that through paying off your car loan early.

    Not everyone has the financial power to pay off a car loan early. If you don't have the funds to do so, you may want to look into other options. Refinancing your car loan gives you the chance to lower your interest rate and reduce how much interest you pay over the life of the loan. But it could also extend your monthly payments, so it's important to choose a financial path that fits your situation.