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Paying off your auto loan before the end of the loan term is attractive if you want to reduce your monthly debt payments more quickly. But making that decision really depends on a few different factors like your current interest rate, your monthly payment, and whether you can afford the final lump sum.
For most people, it might be worth it. But you’ll want to assess your financial situation first before you take the leap.
Benefits of early repayment of a car loan
If you have the funds to pay off your car loan early, you could reap serious benefits.
1. Improve your DTI
Your debt-to-income ratio (DTI) is the amount of debt you owe for the money you earn. The lower your DTI, the better you look to future creditors and lenders, whether it’s taking out a credit card or buying a home. Paying off your auto loan will reduce your DTI.
2. Save money
Each car loan payment is not only the amount you borrowed initially (your principal), but also your interest rate. Paying extra for your principal reduces the amount of interest you will pay over the life of the loan.
Paying off your loan sooner means that it will eventually free up your monthly cash flow for other expenses when the loan is paid off. It also lowers your auto insurance payments, so you can use the savings to hide on a rainy day, pay off other debt, or invest.
3. Own the car
If you pay off your car loan early, you own the car free of charge and with no deductible, rather than the lender. If you ever had to turn around and sell it, you could earn more from that sale than if you still had a loan, because the lender will expect to be paid first from the sale.
Plus, 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 if you drive and maintain it, the car still belongs to someone else as long as it is on loan.
Disadvantages of prepaying a car loan
While there are good things about taking out your car loan early, beware of the downsides.
1. Penalties for early repayment
Some loan contracts come with prepayment penalties, which means that if you pay off your loan before the end of the term, you may have to pay fees.
Keep in mind that there are many contracts in place to prevent buyers from paying off their car loan incredibly early, such as six months after purchase. If you pay off yours two years after the start of your loan, for example, you might not have to pay a fee. But you will need to read your car loan agreement or contact your lender to see if this applies to you.
If you plan to pay off your car early, compare the cost of the fees to the overall savings from paying off your loan well before the deadline. If the cost is greater than the savings, it might not be worth it.
2. Your money could be better spent elsewhere
Paying off your auto loan early frees up a lot of the extra money to keep in your pocket. But it’s also important to look at how much you are paying monthly for other debts that could cost you more. Which one has the higher interest rate? If your car loan rate is low compared to other types of debt, such as credit cards, consider paying off the debt with the highest interest rate first. This way you save more on the total interest owed.
3. Decreased credit score
Every time you pay off debt, it reduces your total credit mix and your open accounts, which can lead to a drop 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 prepay your car loan
Before you pay off your car loan in full, review your options to see which one is best for your financial situation, such as:
- Refund the full amount. In order to pay off the entire remaining balance, it may be necessary to pay a few hundred or thousands of dollars at once, depending on how much is left on your car loan balance.
- Pay partial payment. If you got a bonus at work or maybe sold something for a large amount of change, you can use that money to make a large partial payment on your car loan.
- Boost your monthly payments. If you got a raise at work or a new side activity, you can increase your monthly payments in increments. This will reduce the number of monthly payments you will have to make to pay off your car.
When to consider paying off a car loan
This is an important financial decision and you need to think about it carefully enough just like you did when you first got the car loan. Consider reimbursing your car if:
- You can afford it. If you don’t have other large, more expensive financial obligations, it makes sense to pay off your car loan. You’ll free up money in your budget to spend it on other things. But if you don’t have the cash on hand, you might want to explore other options.
- You have no other outstanding debt. Look at your budget, including how much you earn and what you pay. If you want to save on total interest, you might have other types of debt that are a bigger obligation. Credit cards or personal loans often have higher interest rates than auto loans, which means you may want to devote additional financial resources to them.
- You save for a big purchase. Buying a car in and of itself is a major financial decision, but if you’re trying to save for a home, lowering your DTI ratio and increasing your cash flow is a big deal. You can do this by paying off your car loan early.
Not everyone has the financial capacity to prepay a car loan. If you don’t have the funds to do so, you may want to consider other options. Refinancing your car loan gives you the ability to lower your interest rate and reduce the amount of 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 matches your situation.
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