Do you have extra cash? Maybe you got a bonus at work, received a large tax refund, or another unexpected financial windfall. If you have a car loan, it might make sense for you to use that cash to pay off your car loan.
Paying off your car loan will help you save money on interest payments and can improve your chances of getting a mortgage, but it may hurt your credit score in the near term.
Let’s dive in to explore when it is and isn’t a good idea to pay off your car loan early. If you want to jump to a specific section, please use the links below:
In most cases, paying off a car loan early will save money that would otherwise go toward interest payments — but not if you have a zero percent car loan.
If you have a 0% interest rate, there’s little benefit to paying off your car loan early. You’re better off putting that extra cash toward paying off other high-interest debt or investing the money.
On the other hand, if you have a high-interest car loan with several years of payments remaining, paying off the loan could save you a significant amount.
To illustrate, say you originally financed your car with a $20,000, 72-month loan at 10%. You have 48 months remaining and a balance of $14,609. Paying off the balance would save you over $3,000 in interest.
Paying off a car loan early can help you save money and enjoy a debt-free life faster, but there are potential drawbacks. Do any of these disadvantages apply to you?
If you don’t have enough money in your emergency fund to cover six to nine months of expenses, you’re better off putting your money into a high-yield savings account than paying off your car loan.
Without an emergency fund, unforeseen financial setbacks — such as losing your job or facing an expensive car repair — can force you to pull out a high-interest credit to pay for emergencies. Then any money you saved by paying off your loan goes up in smoke.
Banks and finance companies sometimes include prepayment penalty clauses in auto loan contracts, which require borrowers who pay off their loans early to pay a fee. Before paying off your auto loan early, check your contract to see whether there’s a penalty for paying early and how they calculate the penalty.
If a prepayment penalty offsets the potential interest savings, you’re better off using your extra cash for something else.
Despite the potential downsides, there are many benefits to paying off debt.
Any time you pay off debt, you free up cash in your monthly budget. You can put the amount you would be paying toward your car loan into paying off other debts, saving a down payment for a house, or other financial goals.
As long as you don’t have a zero-interest loan and there’s no prepayment penalty, paying off your car loan early allows you to save money on interest. The amount you’ll save depends on your remaining loan balance and interest rate.
To see how much you’ll save by paying off your loan early, plug your loan details into an auto loan payoff calculator, like this one from BankRate.
Part of the mortgage approval process includes calculating your debt-to-income (DTI) ratio, which compares your monthly debt payments to your monthly income.
According to the CFPB, most lenders require borrowers to have a DTI ratio no greater than 43% to qualify for a mortgage.
For example, say your monthly gross income is $4,000, and you want a mortgage that would cost $1,200 per month. You also have the following debts:
In that case, your DTI (including the potential mortgage payment) would be calculated as:
__($1,200 + $300 + $200 + $100) / $4,000 = 45%__With a 45% DTI, you may have a hard time getting a mortgage. But if you paid off your car loan, your DTI would be 37.5%, which could make finding a mortgage — and qualifying for a decent interest rate — much easier.
Whether you make a lump-sum payment or pay a little extra each month, paying off a car loan early requires making one or more principal-only payments, and your lender may not make it easy.
Some lenders don’t apply extra payments directly to principal. Instead, they’ll apply it first to any interest accrued since your last payment or treat it as an early payment of next month’s principal and interest.
If you want to pay off your car loan early, don’t simply take the balance due shown on the lender’s website or your most recent statement. Call the lender and tell them you’re interested in paying your loan in full or making a lump-sum principal-only payment.
Find out exactly what you need to do to ensure the payment is applied correctly. Your lender may require you to write an extra check for principal-only payment or mail the payment to a different address. Follow their directions, then call again in a couple of weeks to ensure they applied your payment and your loan is truly paid in full.
Getting out of debt is definitely good for your long-term financial health. That’s why it’d hard to believe that paying off a car loan can hurt your credit score. But it can — especially if you’re just starting to build credit. Here’s why.
According to Experian:
“Once your loan is paid off, the account will be closed. Although closed accounts may show you successfully managed credit in the past, open credit accounts have a greater impact on your credit score because they show lenders how well you’re managing credit in the present.”
According to FICO®, credit mix accounts for approximately 10% of your credit score. People with a mix of credit cards and installment loans typically score higher than people with only one type of debt.
If you pay off your car loan and have only one type of account remaining, your credit score could drop.
Length of credit history accounts for around 15% of your FICO credit score and considers the age of your oldest account, among other factors. If your car loan is your oldest account and you pay it off, the account closure could hurt your credit score.
Fortunately, according to Experian, most people only see a minor drop in their credit score, and the change is usually temporary, so don’t let that dissuade you from your goal of getting out of debt.
However, if you’re currently applying for a mortgage and you don’t need to pay off your car loan to qualify, you may want to hold off. That’s when even minor, temporary drops in your credit score can have long-term consequences, so you should wait to pay off your car loan until your mortgage is finalized.
If paying off your car loan isn’t the best use of your cash surplus, consider some other ways that money can come in handy, such as:
Being debt-free, or at least free of monthly car payments, is certainly an excellent position to be in financially. But you should only pay off a car loan early when it works to your advantage.
If you have little or no emergency savings or other high-interest debt, paying off your car may not be your top priority. But if you are otherwise financially stable, run the numbers to make sure paying off your loan is the right financial move.
Janet Berry-Johnson is a Certified Public Accountant and freelance writer with a background in accounting and insurance. Her writing has appeared in Forbes, Freshbooks, The Penny Hoarder, and several other major outlets. See Janet's profile on Linkedin.
Lauren Bringle is an Accredited Financial Counselor® with Self Financial – a financial technology company with a mission to increase economic inclusion by helping people build credit and savings. Connect with her on Linkedin or Twitter.