Let’s say you’re working hard and you finally have enough cash to pay off your car loan in full.
It’s a tempting move: you’ll have one less bill each month, save a few hundred dollars in interest payments, and finally get ownership of your car from your lender (which means you can opt out of full-cover auto insurance). .
But believe it or not, there are also big benefits to meeting a repayment schedule, even if you are able to repay the loan in full.
A brief overview of the basics of car loans
Before we discuss the pros and cons of paying off a loan, let’s recap how car loan payments work.
Main is the total amount of money you borrow to buy a car. So if you buy a car for $30,000 and can make a $5,000 down payment, you will borrow the other $25,000. This is your director.
Interest it is a “fee” charged by a lender for borrowing their money. Interest equals income for creditors; keep that in mind as we dive further.
You may also encounter two different types of interest on your existing and future loan documents:
simple interest, which the vast majority of lenders use, is calculated using your outstanding balance on the due date. Whether you start making payments earlier, more frequently, or simply pay more than your monthly payment, your remaining interest should decrease in real time, allowing you to pay off your loan faster.
Pre-calculated percentage everything is calculated up front and the total interest you owe your lender won’t change even if you start paying off your loan faster.
Whether you pay simple or pre-calculated interest, your early repayment options will make the difference.
As simple interest, some lenders charge you an early repayment fee because they miss out on some of the expected interest, i.e. income.
With pre-calculated interest, lenders tend to care less about how quickly you pay off your loan since they get the same amount of interest either way. For this reason, if you are ever considering a loan with pre-calculated interest, you should definitely make sure that your lender offers return of early repayment.
However, most of the time you will be using the simple interest plan, so we will focus on that in the future.
If I pay extra on a car loan, does it go towards the principal amount?
Car loans are amortized, meaning part of your monthly payment goes towards principal and part goes towards interest.
So, if you pay $1,000 instead of $500 next month, where does the extra $500 go? Principal or interest?
All lenders are different, but many will just see the extra capital and say, “Wow, thanks!” and apply more of it to interest (i.e. pay yourself).
But you’re allowed (and encouraged) to say to your lender, “Hey, please apply this to my principal so I can pay off my loan faster.”
Most lenders have a checkbox somewhere to indicate that you want additional payments to apply to your principal. Check your loan documents or just give them a call to find out what their process looks like.
What happens when you pay off your car loan early?
Generally speaking, lenders will not stop you from their early repayment. After all, any amount of outstanding debt is a risk for them.
However, they may charge you a fee called prepayment penalty.
What is a prepayment penalty?
A prepayment penalty is a fee that a lender charges you for paying off a loan before the end of the scheduled loan term (your designated time period for repayment).
This may sound strange or spiteful, but it’s really just an economic theory.
As our car loan calculator shows, if you take out a $35,000 loan at 5% interest for 36 months, you end up paying about $2,750 in total interest.
Now, if you get a new job and pay off your loan in full in just 18 months, you could save about $1,350 in interest. Good!
But your creditor will like ummm, interest is our income – we’re glad you gave us back what you borrowed, but you’re also forcing us to pay back $1,000.
In the old days, creditors charged you the full $1,000 to get what you owed. But thankfully, the average prepayment penalty these days is just 2% of your outstanding balance, according to Experian. So if you pay off the $3,000 outstanding balance right away, your lender can add a $60 fee to recoup a small percentage of their lost income.
However, some online lenders do not charge any early repayment penalty at all. If you’re trying to choose between two lenders that offer comparable interest rates, the one that doesn’t charge a prepayment penalty has a clear advantage.
Does paying off a car loan help the loan?
Here’s another strange feature of auto loans that catches some borrowers off guard:
Early repayment of a car loan can actually decline your credit score by a few points.
You see, having active credit has the potential to increase the length of your credit history, diversify your credit profile, and demonstrate strong payment habits. Together, these factors make up 60% of your credit score.
When you close your account, it still looks good on your credit report for 10 years, but you’re missing out on the opportunity to keep building credit.
So, if you have 12 months of car payments left and plan to apply for another large loan in 24 months (mortgage, student loan, etc.), you may want to consider making 12 more on-time payments, which will increase your credit score before applying for a much larger loan.
Read more: Is early car loan repayment bad for your credit score?
How to pay off a car loan early
Before deciding whether paying off your car loan early is the right move, let’s look at four repayment options:
- Pay the entire amount at once
- Payment of a partial lump sum (for example, $5,000 with a balance of $10,000).
- Increase your payment (e.g. $600/month instead of $500/month)
- Increase the frequency of payments (for example, $250 on the 1st and 15th instead of $500 on the 1st).
Obviously, you can mix and match by throwing $50 back and forth and opting to pay bi-weekly rather than monthly.
My final early payment hack may seem obvious but is often overlooked:
Call your lender and just talk about early repayment options.
At least a simple question like, “Hey, can we talk about the best way to pay off my loan early?” can lead to enlightening conversation. Some lenders can even help you create the perfect early payment schedule to avoid fees.
So, should you pay off your car loan early?
Let’s look at some of the advantages and disadvantages of early repayment of a car loan. I’ll also add a few other minor considerations that I haven’t mentioned yet.
Advantages of early repayment of a car loan
- Significantly saves money on interest payments
- Reduces your monthly expenses
- Get your car license faster
- Allows you to opt out of full coverage insurance, which saves money on policy renewal time
- Frees up capital to invest elsewhere
- Eliminates the risk of being “upside down” on the loan (owes more than the cost of the car)
- Improves debt-to-income ratio (DTI)
Disadvantages of paying off a car loan early
- Can divert money away from essentials like your emergency fund
- Possible penalties for early repayment
- Can damage your credit score
- It may be wiser to invest money for redemption in I bonds or index funds. (*if* the car loan interest rate is lower, say 4%)
Paying off a car loan early is usually the right move if:
- You can really afford it without causing other financial stress.
- This will save you more money on interest than you spend on prepayment penalties.
- Your credit score will still be high enough to match your immediate borrowing goals, even after a slight dip.
- The interest rate on your loan is higher than the likely return you will receive from the investment.
But if funds are needed to repay more pressing matters, your credit score has serious room for improvement, or the interest rate on your loan is very low, it may actually be wiser to stick to the course of your loan term.