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Paying off your car loan before the end of the loan term is attractive if you want to reduce your monthly 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 to pay the final lump sum.
For most people, it might be worth it. But you’ll want to assess your financial situation first before taking the plunge.
Benefits of prepaying a car loan
If you have the funds to pay off your car loan early, this could have some serious benefits.
1. Improve your DTI
Your debt-to-income ratio (DTI) is the amount of debt you owe compared to the money you earn. The lower your DTI, the better you look to future creditors and lenders, whether it’s withdrawing a credit card or buying a house. Paying off your car loan will reduce your DTI.
2. Save money
Each auto loan payment is not only the amount originally borrowed, your principal, but also your interest rate. Paying extra on your principal reduces the amount of interest you will pay over the life of the loan.
Paying off your loan sooner means it will eventually free up your monthly money for other expenses when the loan is paid off. It also lowers your car insurance payments, so you can use the savings to hide away for a rainy day, pay off other debts, or invest.
3. Own the car
Paying off your auto loan sooner means you own the free and clear car, rather than the lender. If you ever need to turn around and sell it, you could earn more from that sale than if you still had a loan on it, because the lender will expect payment 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 it and maintain it, the car still belongs to someone else as long as there is a loan on it.
Disadvantages of prepaying a car loan
While there are good things about paying off your car loan early, be aware of the downsides.
1. Penalties for prepayment
Some loan agreements have prepayment penalties, which means that if you pay off your loan before the end of the term, you may have to pay a fee.
Keep in mind that many contracts are in place to prevent buyers from paying off their auto loan very early, such as six months after purchase. If you repay yours two years after your loan started, for example, you may not have to pay any fees. But you’ll need to read your auto 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 fees to the overall savings of paying off your loan well before the deadline. If the fees are more than the savings, it may not be worth it.
2. Your money could be better spent elsewhere
Paying off your car loan early frees up a lot of extra money to keep in your pocket. But it’s also important to look at how much you’re paying monthly for other debts that could cost you more. Which has the highest 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 due.
3. Lower credit score
Each time you pay off a debt, it reduces your total credit mix and your open accounts, which can cause your credit score to drop. 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 off your car loan sooner
Before completely paying off your car loan, review your options to see which one best suits 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 all 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 you sold something for a large sum 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 hustle, you can increase your monthly payments in increments. This will reduce the number of monthly payments you need to make to pay off your car.
When to consider paying off a car loan
This is a big financial decision and you need to think about it carefully, just like you did when you got the first car loan. Consider paying off your car if:
- You can afford it. If you don’t have other major and more costly financial obligations, it makes sense to pay off your car loan. You will free up money in your budget to invest in other things. But if you don’t have cash on hand, you might want to explore other options.
- You have no other outstanding debts. Look at your budget, including how much you bring in and what you pay. If you want to save on total interest, you may have other types of debt that represent a larger obligation. Credit cards or personal loans often have higher interest rates than car loans, which means you may want to allocate additional financial resources to them.
- You are saving for a big purchase. Buying a car in 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 repay a car loan early. If you don’t have the funds to do so, you may want to consider other options. Refinancing your car loan gives you the opportunity to lower your interest rate and reduce the amount of interest you pay over the life of the loan. But it could also make your monthly payments longer, so it’s important to choose a financial path that’s right for you.
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